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PROCEEDINGS 


III  111^ 


THE  CONFERENCE 


VALUATION 


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I 


SPECIAL  CLOTH  BOUND  COPY 
OF  THE 

UTILITIES  MAGAZINE 


This  bound  number  contains  the  Proceed- 
ings of  the  Conference  on  Valuation,  held 
in  Philadelphia,  Pa.,  November  10th  to 
13th,  1915,  under  the  auspices  of  the  Utili- 
ties Bureau. 


THE  UTILITIES  BUREAU 

1009  FINANCE  BLDQ.,  PHILADELPHIA 
MoRBis  Llewellyn  Cooke,  Acting  Director 


TRUSTEES 


LOtns  D.  BRA}n>EI8 
FREDERICK  A.  CLEVELAND 
SAMUEL  8.  FELa 
FELIX  FRANKFURTER 


CHARLES  P.  JENKINS 
LEO  S.  ROWB 
CHESTER  B.  ROWELL 
CHARLES  R.  VAN  HISB 


Volume  I. 


THE  UTILITIES  MAGAZINE 
January,  1916. 


Number  S. 


THE  UTILITIES  MAGAZINE 


VOL.  I  — JANUARY,  1916  — NO.  3 


PROCEEDINGS 

OF 

THE    CONFERENCE    ON   VALUATION 

HELD  IN  PHILADELPHIA  NOVEMBER 
10th  to  13th,  1915.  UNDER  THE  AUS- 
PICES    OF     THE     UTILITIES     BUREAU 


TABLE  OF  CONTENTS 


Opening  Remarks. 


MoRMS  Llewellyn  Cooke,  Director  of  Public  Works,  Phila- 
delphia; Acting  Director  of  The  UtUUies  Bureau. 


PART  I 
THE  REPRODUCTION  THEORY 
Criticism  of  Reproduction  Theory  of  Valuation . . . 

John   M.  Eshleman,   Lieutenant-Governor  of  California; 
formerly  President,  California  Railroad  Commission. 

Reproduction  Value  vs.  Fair  Value 

H.  FiNDLAY  French,  Attorney  at  Law,  Baltimore,  Md. 


Discussion . 


12 


17 


RELATION  OF  REPRODUCTION  COST  TO  FAIR 

VALUE 17 

Morris  Knowles,  Consulting  Engineer,  Pittsburgh,  Pa.; 
Director,  Course  in  Valuation  of  Public  Utilities,  Uni- 
versity of  Pittsburgh. 

DISCUSSION  OF  MR.  ESHLEMAN'S  PAPER  ON  "A 
CRITICISM  OF  THE  REPRODUCTION  THEORY 
OF  VALUATION" 22 

Halbert  P.  Gillette,  Consulting  Engineer,  New  York 
City. 

FALLACY  OF  THE  "REPRODUCTION  COST" 
THEORY  IN  DETERMINING  THE  VALUE  OF 
PROPERTY  OF  PUBLIC   UTILITIES 25 

A.  B.  Dxj  Pont,  Consulting  Engineer,  Cleveland,  Ohio. 

Open  Discussion 27 

James  E.  Allison,  Consulting  Engineer;  formerly  Public 

Service  Commissioner,  St.  Louis,  Mo 27 


PART  II 

ORIGINAL  COST  ' 

How  to  Get  Rid  of  the  Reproduction  Cost  Theory  . 

George  W.  Anderson,  Attorney  at  Law,  Boston,  Mass.; 
formerly  Public  Service  Commissioner  of  Massachusetts. 

Original  Cost  as  the  Chief  Basis  for  Fair  Value 

Dr.  Edward  W.  Bemis,  City  Representative  on  Board  of  Su- 
pervising Engineers,  Chicago;  Member  of  the  Advisory 
Board  to  the  Division  of  Valuation  of  The  Interstate 
Commerce  Commission. 

Original  Cost 

Halford  Ebickson,  Chairman,  Wisconsin  Railroad  Cortv- 


36 


43 


Constitutionality  of  Historical  Cost  Method  of  Public 
Utility  Valuation 46 

Alfred  Bettman,  Attorney  at  Law,  Cincinnati,  Ohio. 

Discussion 51 

ACTUAL  COST 61 

Dr.  Robert  H.  Written,  Secretary,  Board  of  Estimate 
and  Apportionment,  Committee  of  City  Plan,  New  York 
City. 

FAIR  VALUE  IN  PRACTICE 54 

Edward  P.  Burch,  Consulting  Engineer,  Detroit,  Mich. 

Open  Discussion 55 

John  H.  Grat,  Professor  of  Economics,  University  of  Minne- 


sota. 


George  W.  Anderson,  Attorney  at  Law,  Boston,  Mass. .  .  55 
F.   W.  Stevens,   General   Valuation  Counsel,   New   York 

Central  Lines,  New  York  City 55 

Frederic  P.  Stearns,  Consulting  Engineer,  Boston,  Mass.  56 
John  M.  Eshleman,  formerly  President,  California  Rail- 
road Commission 57 

Robert  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 


JoHN  M.  Eshleman,  formerly  President,  California  Rail- 
road Commission 


27 


58 

Oscar  F.   Gatton,   Valuation  Supervisor,  Department  of 

Public  Service,  Chicago 58 

Dr.  Edward  W.  Bemis,  Member  of  the  Advisory  Board  to 
the  Division  of  Valuation  of  the  Interstate  Commerce 
Commission 68 


^  HP'^q 


THE      UTILITIES      MAGAZINE 


PART  III 

FRANCHISE  VALUES 
Principles  as  to  Franchise  Values 59 

Dr.  Delos  F.  Wilcox,  Consulting  Franchise  and  Public; 
Utility  Expert,  New  York  City;  Deputy  Commissioner, 
Department  of  Water  Supply,  Gas  and  Electricity. 

Determining  Franchise  Values 67 

Henry  DeForest  Baldwin,  President  and  Counsel  of  the 
Queens  County  Water  Company,  New  York  City. 

Discussion 72 

SOME  DISTINCTIONS  BETWEEN  THE  LEGAL 
AND  ADMINISTRATIVE  PHASES  OF  FRAN- 
CHISE VALUATION.  • 74 

Chester  A.  McLain,  Lecturer,  Harvard  University. 

THEORY  OF  FRANCHISE  VALUES 74 

Alfred  Bettman,  Attorney  at  Law,  Cincinnati,  Ohio. 

Open  Discussion 76 

Harry  Barker,  Editor,  Engineering  News 76 


PART  IV 

LAND  VALUES 
Principles  to  be  Applied  in  Valuing  Land 77 

Hammond  V.  Hayss,  Consulting  Engineer,  Boston,  Mass. 

Discussion 84 

LAND  VALUES  UNDER  THE  MINNESOTA  RATE 

CASE 84 

Thomas  D.  O'Brien,  Counselor  at  Law,  St.  Paul,  Minn. 
{Counsel  for  Minnesota  in  Minnesota  Rate  Case.) 

THE  MEASUREMENT  OF  LAND  VALUES 85 

Edward  W.  Doty,  with  Cdumbus  (Ohio)  Railway  Power 
and  Light  Company;  formerly  Member  of  The  Public 
Utilities  Commission  of  Ohio. 

PRINCIPLES  TO  BE  APPLIED  IN  VALUATION  OF 
LANDS  USED  FOR  THE  PURPOSE  OF  A  COM- 
MON CARRIER 88 

A.  E.  Helm,  Commerce  Counsel,  Kansas  Public  Utilities 
Commission. 

DISCUSSION 91 

John  M.  EsHLEMAN,/orjn«rZj  President,  California  Rail- 
road Commission. 

DISCUSSION  OF  PRINCIPLES    TO    BE  APPLIED 

IN  VALULSIG  LAND 92 

F.  W.  Stevens,  General  Valuation  Counsel,  New  York 
Central  Lines;  formerly  Chairman,  Public  Service  Com- 
mission, Second  District,  New  York. 

THE  PROPER  TREATMENT  OF  APPRECIATION 

OF  LAND 96 

Dr.  Milo  R.  Maltbie,  Member  of  the  Advisory  Board  to 
the  Division  of  Valuation  of  the  Interstate  Commerce 
Commission;  formerly  Public  Service  Commissioner, 
First  District,  New  York. 

Open  Discussion 97 

James    C.     Bonbrioht,     Graduate    Student,     Columbia 

University 97/ 

F.  W.  Stevens,  General  Valuation  Counsel,  New  York  Cen- 
tral Lines 98 

Harry  Barker,  Editor,  Engineering  News 98 

Dr.  Edward  W.  Bemis,  Member  of  the  Advisory  Board  to 
the  Division  of  Valuation  of  the  Interstate  Commerce 
Commission 99 

Dr.  Milo  R.  Maltbie,  Member  of  the  Advisory  Board  to 
the  Division  of  Valuation  of  the  Interstate  Commerce 
Commission 99 

A.  M.  Sakolski,  Secretary,  Valuation  Committee,  The  Del- 
aware and  Hudson  Company,  Albany,  New  York ....       99 

John  Bauer,  Assistant  Professor  of  Economics,  Cornell 

University 100 


PART  V 

DEPRECIATION 
Depreciation  Defined 100 

Frederic  P.  Stearns,  Consulting  Engineer,  Boston,  Mass. 

Court  Decisions  on  Depreciation 102 

J.  H.  GoETz,  of  Counsel,  Public  Service  Commission,  First 
District,  New  York  City 

Depreciation  and  Its  Relation  to  the  Fair  Value 112 

Halford  Erickson,  Chairman  of  Wisconsin  Railroad 
Commission. 

Discussion 124 

A  CRITICISM  OF  THEORETICAL  DEPRECIATION    1584 

James  E.  Allison,  Consulting  Engineer;  formerly  Public 
Service  Commissioner,  St.  Louis,  Mo. 

DISCUSSION 127 

John  Bauer,  Assistant  Professor  of  Economics,  Cornell 
University. 

MAKING  DEPRECIATION  DISCUSSION  UNDER- 
STOOD      131 

Harry  Barker,  Editor,  Engineering  News. 
Open  Discussion 132 

Allyn  a.  Young,  Professor  of  Economics,  Cornell  Uni- 
versity       ISii 

Robert  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 
versity       132 

A.  M.  Sakolski,  Secretary,  Valuation  Committee,  The  Dela- 
ware and  Hudson  Company,  Albaiiy,  New  York 133 

Prof.  John  Bauer,  Assistant  Professor  of  Economics,  Cor- 
nell University 133 

M.  G.  Lloyd,  Technical  Editor,  Electrical  Review  and  West- 
ern Electrician 133 

Oscar  F.  Gayton,  Valuation   Supervisor,   Department  of 

Public  Service,  Chicago 133 

L.  K.  Frank,  Accountant,  New  York  Telephone  Company, 

New  York  City 133 

Frank  Seidman,  Accountant,  Public  Service  Commission, 

First  District,  New  York 134 

Dean  Lanqmuir,  Statistician,  New   York  Public  Service 

Commission,  First  District,  New  York 134 

James  E.  Allison,  Consulting  Engineer,  St.  Louis,  Mo. . . .  134 

Harry  Barker,  Editor,  Engineering  News 135 

John  M.  Eshleman,  formerly  President,  California  Rail- 
road Commission 136 


PART  VI 

GOING  VALUE 
Introductory  Remarks 137 

Morris  Schaff,  Commissioner,  Massachusetts  Board  of  Gas 
and  Electric  Light  Commissioners. 

Going  Value  as  an  Element  of  Fair  Value 138 

Clifford  Thorne,  Chairman,  Iowa  Board  of  Railroad 
Commissioners;  formerly  President  of  the  National  Asso- 
ciation of  Railway  Commissioners. 

Discussion 152 

DISCUSSION 152 

Joseph  L.  Bristow,  CAoirmon  of  the  Kansas  Public  Util- 
ities Commission. 

GOING  VALUE  IN  PURCHASE  VS.  RATE  CASES. .     163 
A.  M.  Fox,  Engineer  for  Telephone  Committee,  Detroit, 
Mich. 

DISCUSSION 155 

William  J.  Haqbnah,  Public  Utility  Statistician,  Chicago, 
lU. 


CONTENTS 


3 


Open  Discussion 158     Discussion 187 

DISCUSSION 187 


Clifford  Thohne,  Chairman,  Iowa  Board  of  Railroad 

Commisdoners 158 

William  J.  Hagenah,  Public  Utility  Statistician,  Chicago, 

111 158 

Robert  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 
versity       158 

John  Bauer,  Assistant  Professor  of  Economics,   Cornell 

University 168 

Chas.  W.  McKay,  Consulting  Engineer,  Chicago,  III 160 


PART  VII 

UNIT  PRICES 
The  Problem  of  Unit  Prices  in  Valuation 161 

M.  G.  Glaeser,  Statistician,  Wisconsin  Railroad  Cotrtr 


PART  VIII 

FINANCIAL  ASPECTS  OF  VALUATION  AND 
REGULATION 

Financial  Aspects  of  Valuation 165 

Paul  A.  Sinsheimer,  Bond  Expert  of  California  Railroad 
Commission. 

Financial  Aspects  of  Regulation 170 

Robert  C.  Wood,  Public  Service  Commiationer  for  the  First 
District,  Staie  of  New  York. 


PART  IX 

MAKING  AND  MAINTENANCE  OF  PRICED 
INVENTORIES 

The  Making  and  Maintenance  of  Priced  Inventories 
of  Public  Utilities 171 

Charles  L.  Pillsburt,  Chief  Engineer,  Valuation  Bureau, 
Public  Utilities  Commission,  District  of  Columbia. 

Discussion 179 

DISCUSSION 179 

James  W.  Phillips,  (}rade  Crossing  Division,  Bureau 
of  Surveys,  Philadelphia. 

SOME   ESSENTIALS  OF   APPRAISAL  WORK 179 

P.  W.  Ballard,  Commissioner  and  Chief  Engineer,  Divi- 
sion of  Light  and  Heat,  Cleveland,  Ohio. 

CO-OPERATION    IN  MAKING  INVENTORIES ... .     181 
R.  J.  Meigs,  Valuation  Engineer,  Western  Union  Tele- 
graph Company,  New  York  City. 

PART  X 

VALUATION  BY  APPROXIMATION 

Valuation  by  Approximation 183 

John  G.  Morse,  Appraiser,  Associated  Factory  Mutual 
Fire  Insurance  Companies,  Boston,  Mass. 


Alexander  Potter,  Consulting  and  Constructing  Engi- 
neer, New  York. 

DISCUSSION 188 

Morris  Llewelltn  Cooke,  Director  of  Public  Works, 
Philadelphia. 

CORRECT    VALUATION    OF    OPERATING    AND 

MANAGERIAL  METHODS 190 

Walter  N.  Polakov,  Consulting  Engineer,  Stamford, 
Conn. 

Open  Discussion 191 

Dean  Langmuih,  Statistician,  Public  Service  Commission, 

First  District,  New  York 191 

P.  W.  Stevens,  General  Valuation  Counsel,  New  York  Cen- 
tral Lines,  New  York  City 191 

John  G.  Morse,  Appraiser,  Associated  Factory  Mutual 

Fire  Insurance  Companies,  Boston,  Mass 192 

Robert  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 
versity       192 


PART  XI 

OPINION  TESTIMONY 

Expert   (or  Opinion)  Testimony  in  Rate  Valuation 
Cases  192 

John  H.  Gray,  Professor  of  Economics,  University  of  Min- 
nesota. 

PART  XII 

CONSTITUTIONAL  PROTECTION  IN  VALUATION 

The  Meaning  of  the  Constitutional  Protection  in  Val- 
uation       204 

Charles  A.  Prouty,  Director  of  Valuation,  Interstate  Com- 
merce Commission. 

Constitutional  Protection  in  Valuation 208 

WiLLLAM  D.  Kerr,  Attorney  at  Law,  Chicago,  III. 

Discussion 215 

CONSTITUTIONAL  PROTECTION  IN  VALUATION    215 
Newton  D.  Baker,  Mayor  of  Cleveland,  Ohio. 

DISCUSSION  OF  PAPERS  BY  MR.  PROUTY  AND 

MR.  KERR 217 

A.  L.  Valentine,  Superintendent,  Department  of  Public 
Utilities,  Seattle,  Wash. 


PART  XIII 

VALUATION  AND  THE  FUTURE  OF  PUBLIC 
UTILITIES 

Valuation  and  the  Future  of  Public  Utilities 218 

Dr.  Milo  R.  Maltbie,  Member  of  the  Advisory  Board  to 
the  Division  of  Valuation  of  the  Interstate  Commerce 
Commission;  formerly  Public  Service  Commissioner,  New 
York  City. 


328230 


THE      UTILITIES      MAGAZINE 


OPENING  REMARKS 

By  Morris  Llewellyn  Cooke 

Director  of  Public  Works,  City  of  Philadelphia;  Acting  Director  of  the  Utilities  Bureau 


THE  values  and  near  values  which  this  Valuation 
Conference  held  under  the  auspices  of  the  Utili- 
ties Bureau  was  called  to  discuss,  total  tens 
of  billions  of  dollars,  including  as  they  do  the  prop- 
erty of  all  gas,  water,  traction,  electric,  telephone  and 
telegraph  companies  together  with  the  steam  railroads. 

Until  the  time  of  the  Mayors'  Conference,  held  about 
a  year  ago — resulting  as  it  did  in  the  formation  of  the 
Utilities  Bureau — no  forum  existed  devoted  primarily 
to  the  competent  and  free  discussion  of  utility  prob- 
lems. Even  had  there  existed  such  a  debating  ground, 
the  cities  of  the  country  stood  so  far  aloof  from  each 
other  in  utility  matters,  and  correspondence  between 
interested  citizens  was  so  diflBcult,  that  there  was 
afforded  no  means  of  passing  out  information  about 
even  well-established  standards  and  policies.  Today 
this  is  all  changed.  Through  the  Utilities  Magazine, 
our  lists  of  thousands  of  city  officials  and  others  specially 
interested  in  utility  matters  and  our  corps  of  consulting 
experts,  the  Utilities  Bm-eau  has  become  an  influential 
agency  not  alone  for  the  study  and  solution  of  utility 
problems,  but  for  the  education  of  the  cities  of  America 
in  these  matters. 

Our  first  conference  was  devoted  to  the  whole  utility 
field  and  a  long  list  of  papers  was  presented  bearing  on 
ownership,  operation,  rates,  franchises  and  regulation. 
This  conference  is  limited  to  the  one  question  of  valu- 
ation. It  is  our  plan  to  call  from  time  to  time  other 
conferences  at  which  there  can  be  taken  up  in  an 
authoritative  manner  other  individual  problems  which 
go  to  make  up  this  great  utility  problem — transcended 
in  genuine  importance  in  my  opinion  by  no  other 
problem  of  American  life  except  the  liquor  question. 

The  importance  of  the  valuation  feature  in  this  field 
has  been  emphasized  by  the  companies  themselves 
rather  than  by  the  community.  And  on  the  company 
side  it  is  a  point  of  special  interest  to  those  who  plan 
the  financing  of  utility  companies  and  who  market 
their  securities  rather  than  either  to  those  who  operate 
these  properties  or  the  actual  investor — however  much 
these  last  two  may  have  at  stake  in  the  fair  settlement 
of  the  questions  involved.  As  far  as  I  know  there  is 
no  desire  anywhere  to  keep  from  the  actual  investor 
a  fair — even  a  full — return  on  the  money  actually 
invested  in  this  group  of  properties. 

Throughout  the  utility  industry  and  especially  as 
to  these  question  of  valuations,  there  is  the  widest 
diversity  of  opinion  even  as  between  conservative  men, 
representing,  on  the  one  hand,  the  public  point  of  view 


and,  on  the  other,  the  attitude  of  the  owners  of  utility 
securities.  The  controversy  between  the  reproduction 
theory  of  value — as  opposed  to  the  historical  or  cost 
value — is  a  case  in  point.  Most  if  not  all  of  those  who 
devote  their  time  exclusively  to  upholding  the  public 
side  of  these  questions  adhere  to  the  principle  that  after 
all  is  said  and  done  the  amount  of  cash  honestly  invested 
in  a  property  is  the  one  best  test  of  its  fair  value,  how- 
ever many  other  important  considerations  it  may  be 
well  to  take  into  account.  On  the  other  hand,  it  must 
be  admitted  that  those  who  have  their  millions  in- 
vested in  these  properties  hold  just  as  tenaciously  and 
even  more  unitedly  to  the  theory  that  we  should  esti- 
mate the  value  of  a  property  very  largely  by  a  more  or 
less  theoretical  computation  as  to  what  it  would  cost 
to  reproduce  it. 

Again,  in  the  matter  of  depreciation,  we  have  good 
men  on  the  public  side  who  advocate  following  what 
used  to  be  considered  a  proper — certainly  a  conserva- 
tive— practice  in  industry  of  writing  off  such  heavy  de- 
preciation as  to  make  the  plant  stand,  after  a  few  years, 
at  a  ridiculously  low  figure  on  the  books.  On  the  other 
hand,  I  have  recently  received  a  lecture  of  a  well- 
known  college  president  who  works — sometimes  at 
$1,000  a  day — for  the  utility  companies,  which  seems  to 
argue  that  to  depreciate  a  utility  property  is  old-fash- 
ioned. Then  as  to  the  value  of  the  franchise  itself,  as 
to  the  mechanical  methods  to  be  followed  in  making 
the  inventory  and  in  almost  every  other  matter,  we 
seem  to  be  as  far  apart  as  the  poles. 

Now  much  of  this  results  from  our  not  having  the 
facts.  Some  of  it  comes  from  the  public  not  knowing 
the  facts  we  have.  Some  of  it  undoubtedly  comes  from 
pure  cussedness  on  both  sides.  I  don't  know  that  the 
Utilities  Bureau  ca^  look  forward  to  reforming  in  any 
large  way  the  temperamental  tendencies  of  either 
the  friends  or  the  Enemies  of  the  square  deal  in  this 
field.  But  there  is  a  tremendous  work  we  can  do  in  the 
development  of  sound  policies  in  all  these  matters  and 
in  the  establishment  of  standards  wherever  they  are 
possible.  We  have  an  even  greater  work  to  perform  in 
interpreting  all  these  technical  matters  to  the  lay  public. 

Following  the  practice  used  in  the  Mayors'  Confer- 
ence, every  effort  was  made  to  give  the  representatives 
of  these  private  utility  interests  the  fullest  possible 
opportunity  to  be  heard  at  each  of  our  sessions.  Every 
person  even  discussing  a  paper  was  asked  to  discuss 
the  topic  as  well  as  the  paper.  In  order  that  the  vol- 
ume of  transactions  of  this  conference  may  be  as  com- 


THE      REPRODUCTION      THEORY 


plete  as  possible,  the  authors  of  papers  and  prepared 
discussions  will  be  permitted  to  amend  or  add  to  their 
contributions,  even  after  the  close  of  the  conference. 
We"  want  the  record  of  these  meetings  to  be  as  illumi- 
nating as  possible  from  every  point  of  view.  While 
the  conference  was  called  with  the  object  of  develop- 
ing fully  the  public  view,  to  have  the  opposite  side  ably 
presented,  as  is  the  case,  can  only  assist  in  developing 
the  wise  course  for  the  public  in  all  these  matters. 


The  private  interests  are  never  without  able  cham- 
pions in  all  these  matters.  Too  frequently  the  public 
interest  has  been  almost  ignored  in  these  discussions. 

This  conference  was  planned  on  the  assumption  that 
what  is  fair,  and  what  is  true,  and  what  is  honest,  and 
what  is  for  the  upbuilding  of  our  great  country  and 
the  well-being  of  its  living  and  unborn  millions  will, 
in  the  last  analysis,  conserve  the  private  as  well  as 
the  public  interest  in  these  properties. 


A  CRITICISM  OF  THE  REPRODUCTION  THEORY  OF  VALUATION 

By  John  M.  Eshleman 

Lieutenant  Governor  of  California,  formerly  President  of  the  California  State  Railroad  Commission 


"All  that  is  beneficial  in  property  arises  from  its  use  and 
the  fruits  of  that  use;  and  whatever  deprives  a  person  of 
them  deprives  him  of  all  that  is  desirable  or  valuable  in  the 
title  and  possession.  If  the  constitutional  guaranty  extends 
no  further  than  to  prevent  a  deprivation  of  title  and  posses- 
sion, and  allows  a  deprivation  of  use  and  the  fruits  of  that 
use,  it  does  not  merit  the  encomiums  it  has  received." 

SO  SAID  Justice  Field  in  his  strong  dissenting 
opinion  in  the  Munn  case  (Munn  vs.  Illinois, 
94  U.  S.  113),  and  although  history  has  demon- 
strated the  correctness  of  the  determination  of  the 
majority  of  the  court  in  that  celebrated  case  and  the 
incorrectness  of  the  conclusions  of  Justice  Field,  still 
the  statement  here  quoted  stands  unchallenged  and  is 
a  correct  statement  of  an  economic  principle. 

There  is  no  difference  whatsoever  between  the  reduc- 
tion of  the  income  of  a  property  by  25  per  cent  and  the 
taking  away  of  one  fourth  of  the  property  from  the 
owner  as  far  as  beneficial  results  are  concerned.  Yet 
whenever  government  reduces  rates  government  does 
just  this,  and  destroys  value,  if  you  please,  as  com- 
mercially understood.  What  Justice  Field  did  not 
desire  to  admit  was  the  right  of  government  so  to 
destroy  value;  and  even  at  this  late  date  the  majority 
of  utility  lawyers  and  utility  commissioners  apparently, 
though  perhaps  they  do  not  recognize  the  fact,  still 
assume  the  position  of  Justice  Field. 

It  is  unfortunate  from  the  standpoint  of  clearness 
that  the  term  "value"  has  ever  entered  into  the  dis- 
cussion of  the  regulation  of  utilities.  It  has  no  place 
there  and  can  not,  in  the  nature  of  things,  be  an  ele- 
ment to  be  considered  in  solving  the  problems  that 
must  be  solved  either  in  fixing  rates  or  determining  a 
price  which  shall  be  paid  for  a  utility  property.  Value 
is  at  most  but  comparative.  In  fact  it  is  always 
personal  and  subjective,  and  varies  with  the  use  to 
which-  the  valued  object  is  to  be  put,  while  price  is  at 


all  times  objectively  determined.  I  am  not  here 
speaking  of  the  confused  definitions  of  these  terms  that 
innumerable  court  decisions  have  produced,  but  of 
their  philosophic  and  economic  significance,  independ- 
ent of  the  confusion  that  attaches  to  them  in  utility 
discussions. 

Plato,  speaking  through  Socrates,  points  out  that  in 
order  to  know  whether  or  not  a  thing  is  good  we  must 
first  determine  the  use  for  which  it  is  intended.  The 
work  of  a  knife  is  cutting,  and  an  instrument  may  be 
very  good  for  cutting  and  still  not  serviceable  at  all  to 
be  used  in  writing,  for  example.  And  in  determining 
the  comparative  worth  of  two  instruments  we  must 
always  compare  their  worths  in  reference  to  the  same 
function,  but  no  instrument  has  ultimate  value  except 
it  be  measured  in  the  need  of  the  one  desiring  to  use  it. 
The  worth  of  a  thing  to  an  individual  will  be  deter- 
mined by  that  individual  in  view  of  the  necessity  of 
his  having  it  and  the  price  determined  by  the  power  of 
the  one  possessing  it  to  withhold  it  or  its  substitute 
from  him. 

Let  us  assume,  for  the  sake  of  argument,  that  the 
desire  to  preserve  actual  physical  life  in  an  extremity 
will  ordinarily  cause  the  surrender  by  the  person  in- 
volved of  more  possessions  not  directly  useful  for  the 
prolongation  of  life  than  will  any  other  motive.  As- 
suming this  to  be  true,  the  one  in  possession  of  the 
only  supply  of  food  can  always  take  from  a  person  in 
dire  need  of  such  food  all  of  his  other  possessions.  Thus . 
we  see  that  value,  viewed  subjectively  as  it  ought  to  be, 
is  always  determined  comparatively  and  personally. 
Comparatively,  because  the  sacrifice  that  will  be  made 
by  the  one  in  whose  mind  the  value  is  fixed  is  deter- 
mined by  the  sacrifice  that  must  be  made  to  secure  a 
substitute  for  the  thing  valued ;  and  personally,  because 
the  ultimate  sacrifice  that  will  be  made  to  secure  the 
object  is  determined  by  the  estimate  the  one  valuing 


6 


THE      UTILITIES      MAGAZINE 


puts  upon  the  desirability  of  his  condition  in  possession 
of  the  object  and  not  in  possession  of  it.  Price,  there- 
fore, when  determined  independent  of  cost  is  merely 
the  money  or  barter  equivalent  of  the  value  thus 
determined.  Its  maximum  is  limited  solely  under  cer- 
tain conditions  by  the  resources  of  the  buyer;  its  mini- 
mum under  certain  other  conditions  may  even  be 
nothing.  In  the  case  just  referred  to,  the  one  in  pos- 
session of  the  sole  supply  of  food  if  so  minded  might 
take  all  the  one  in  need  possessed,  but  plainly  the 
amount  that  could  be  taken  as  the  price  would  be 
determined  and  limited  absolutely  by  the  amount 
possessed  by  the  purchaser  and  would  have  no  relation 
whatsoever  to  the  cost  to  produce  the  article  sold  and 
might  be  many  times  more,  might  be  much  less  than 
such  cost  price.  The  price  thus  determined  for  lack 
of  a  better  name  I  shall  call  threat  price.  And  when- 
ever in  any  price  asked  for  any  commodity  there  is 
present  partially  or  entirely  as 
determining  such  price  this  ele- 
ment, we  shall  recognize  the 
price  to  be  received  by  such 
owner  to  be  partially  or  entirely 
determined  by  such  threat,  and 
the  value  or  worth  to  the  one 
purchasing,  which  induces  such 
a  one  to  pay  the  price  involved, 
to  be  likewise  determined. 

Now  I  do  not  for  a  moment 
imagine  that  I  am  stating  to 
you  anything  with  which  you 
are  not  all  familiar  nor  am  I 

flattering  myself  that  I  am  announcing  any  new  or 
important  economic  principle.  I  do,  however,  con- 
tend that  there  has  been  what  seems  to  me  to  be  a  total 
failure  to  realize  the  connection  between  the  well- 
known  principles  here  announced  and  the  valuation  of 
public  utility  properties. 

In  a  complex  society  such  as  we  now  have  there  can 
not  be  at  all  times  present  in  any  industry  actual  com- 
petition. Even  the  patron  of  a  country  store  is  at  the 
moment  of  making  his  purchase  subject  to  the  possi- 
bility of  some  slight  extortion.  That  price  may  be 
charged  to  the  customer  which  represents  the  price 
which  must  be  paid  to  the  competitor  plus  the  cost  to 
such  customer  of  the  inconvenience,  however  small,  of 
going  to  the  competitor  in  the  same  line  of  business. 
The  effect  of  this  on  prices  is  always  shown  in  new 
countries,  for  example,  where  the  supply  is  limited  and 
the  competitors  far  removed. 

In  the  main,  however,  in  what  we  know  as  competi- 
tive industry  the  tendency  to  add  a  threat  price  to 
what  we  call  the  cost  price  is  or  may  be  regulated  within 
reasonable  bounds  by  competition  actual  or  potential. 


PART  I 
THE  REPRODUCTION  THEORY 


In  industry  where  such  competition  exists,  the  tendency 
always  is  for  the  one  selUng  to  furnish  his  commodity 
or  his  service  at  a  price  which  will  always  have  a  ten- 
dency to  approximate  the  actual  cost  to  the  one  selling, 
including  all  elements,  of  the  commodity  sold  or  the 
service  rendered;  for  merchant  A  knows  that  in  order 
to  get  customers  he  must  make  the  lowest  price  he  can 
reasonably  afford  and  carry  on  the  business,  for  if  he 
does  not  the  customer  will  patronize  merchant  B  who 
does  so;  and  the  tendency  in  any  competitive  industry 
is  for  the  most  efficient  to  fix  the  price.  It  may  well 
be  that  such  an  efficient  one  may  make  considerably 
larger  profit  than  it  will  be  necessary  for  him  to  make 
and  carry  on  his  business  because  of  his  very  efficiency, 
but  this  does  not  affect  the  general  tendency  we  have 
noted. 

Under  conditions  of  similar  costs,  therefore,  the  ten- 
dency  under   competition   is   always   toward   similar 

prices,  and  this  result  obtains 
regardless  of  time  or  place  of 
carrying  on  the  business  if 
actual  competition  exists.  In 
short,  the  tendency  under  com- 
petition is  toward  the  cost  of 
doing  the  business,  that  is, 
toward  the  cost  price,  as  we 
are  here  understanding  it. 

However,  as  the  effect  of 
competition  is  lessened  we  have 
uniformly  seen  enter  the  ele- 
ment of  threat  price.  Often 
it  is  unrecognized,  but  always 
it  is  there.  I  have  in  mind  that  we  will  be  here  con- 
fronted with  an  example  of  the  large  combinations  that 
have  been  built  up  and  have  actually  reduced  the 
prices  of  the  commodities  below  that  which  existed 
under  competition. 

In  this  paper  it  will  be  impossible  to  go  into  this 
aspect  of  the  question  in  detail,  but  it  is  sufficient  to 
say  that  a  study  of  the  history  of  these  combinations 
will  show  that  they  have  in  many  instances  usurped  a 
field  of  possible  competition  and  that  the  threat  of 
future  competition  has  a  potent  effect  upon  their 
activities,  and  besides  there  is  no  evidence  to  show  that 
the  prices  charged  by  these  large  combinations,  even 
though  lower  than  charged  by  the  units  formerly  com- 
peting, are  as  near  the  cost  price  as  was  the  case  before 
the  combinations  were  effected.  In  short  we  may  not 
say  they  are  not  now  exacting  a  threat  price.  From 
the  standpoint  of  society,  however,  it  is  always  desira- 
ble that  prices  charged  shall  have  a  reasonable  relation 
to  cost  price.  Mankind  as  a  whole  is  interested  in  any 
plan  which  tends  to  determine  rewards  in  relation  to 
efforts.     As  a  part  of  organic  society  we  each  admit  the 


WHY  IT  HAS  BEEN  URGED 

ITS  EFFECT  UPON  PUBLIC  WELFARE 

IS  IT  RELATED  TO  FAIR  VALUE 

WHEN  AND  WHERE  SHOULD  IT  BE  USED 

COURT  DECISIONS  THEREON 


THE      REPRODUCTION      THEORY 


justice  and  desirability  of  this  as  an  abstract  proposi- 
tion; as  an  individual  we  also  each  admit  both  its 
justice  and  its  desirability  as  concerns  the  other  fellow 
when  dealing  with  us;  but  we  always  instinctively 
shrink  from  accepting  it  and  applying  this  rule  to  our- 
selves and  the  concrete  enterprise  we  have  in  hand. 
Mankind  is  so  constituted  that  if  left  free  to  work  upon 
the  necessities  of  others  it  has  uniformly  taken  good 
measure  for  its  service,  and  a  study  of  the  activities  of 
those  in  control  of  necessities  and  possessed  of  the 
power  to  impose  a  threat  price,  demonstrates  that  they 
do  so  when  permitted. 

But  in  the  realm  of  a  public  utility  we  have  a  situa- 
tion that  is  peculiar.  We  have  here  an  agency  that  to 
many  of  its  patrons  always  is  a  monopoly,  and  I  have 
no  hesitancy  in  saying,  if  properly  controlled,  it  should 
be  permitted  to  continue  as  a  monopoly. 

I  do  not  propose  to  discuss  this  point  further,  as  I 
assume  it  will  be  admitted  that  a  public  utility  is  a 
monopoly  of  the  kind  that  should  be  regulated  regard- 
less of  the  determination  that  other  monopolies  shall 
be  destroyed  as  monopolies  or  shall  be  regulated  as 
such.  All  monopolies  possess  the  power  of  imposing  a 
threat  price  and  of  producing  a  threat  value  to  the 
patron.  It  was  the  failure  to  recognize  that  the  ware- 
houses, decided  to  be  subject  to  regulation  in  the  Munn 
case,  possessed  this  power  to  extort  that  led  Justice 
Field  to  dissent.  He  was  apparently  right  in  saying 
that  the  decision  of  the  Supreme  Court  of  the  United 
States  in  this  celebrated  case  destroyed  value,  but  he 
was  wrong  in  deciding  that  the  court  had  not  the  right 
to  resort  to  such  destruction.  It  is  for  the  very  pur- 
pose of  destroying  such  value  or  of  preventing  it  from 
coming  into  being — which  is  the  same  thing — which 
gives  warrant  for  regulation  of  utilities  and  all  monopo- 
lies, as  far  as  that  is  concerned.  As  regards  monopolies 
in  naturally  competitive  fields,  of  course,  it  may  be 
urged  that  they  should  merely  be  destroyed  leaving 
the  natural  competitive  forces  to  bring  about  a  condi- 
tion where  the  tendency  of  the  seller  is  to  impose  the 
cost  price,  as  we  have  shown  is  the  tendency  where 
bona  fide  competition  exists.  But  so  soon  as  we  admit 
that  public  utilities  or  natural  monopolies  should  not 
be  destroyed  as  such  monopoUes  then  do  we  present 
the  necessity  of  devising  a  method  of  preventing  them 
from  imposing  a  threat  value  and  securing  a  threat 
price.  In  short,  we  say  to  these  agencies,  "You  may 
not  be  permitted  to  take  all  you  can  get.  Government 
will  only  allow  you  what  you  ought  to  take."  And 
when  we  have  said  this  we  have  placed  government  in 
the  position  of  determining  the  "ought."  How  govern- 
ment should  proceed  to  determine  this  is  the  problem 
that  confronts  the  representative  of  government  in 
regulating  utilities.     Its  very  statement,  however,  sug- 


gests the  consideration  of  equitable  as  against  strictly 
legal  principles,  as  is  always  the  case  when  we  seek  to 
determine  rights  in  terms  of  obligations;  to  determine 
debts  in  terms  of  merits  and  not  power. 

Some  may  be  wondering  what  all  this  has  to  do  with 
a  criticism  of  the  reproduction  theory  of  valuation. 
In  my  opinion  these  principles  must  be  understood 
and  their  relationship  to  the  public  utility  realized 
before  we  are  in  a  position  to  criticize  any  theory  of 
valuation  in  this  field.  When  we  are  left  to  determine 
the  earning  an  agency  ought  to  take,  we  always  will 
have  primarily  before  us  what  the  agency  has  done; 
what  effort  it  has  put  forth;  what  sacrifice  it  has  made. 
And  when,  having  marshalled  all  the  facts  that  may  be 
secured  bearing  upon  this  main  question,  we  have  fixed 
an  earning  or  have  determined  a  basis  upon  which  an 
earning  should  be  permitted,  then  this  basis  is  the 
"fair  value"  of  the  property. 

Does  the  reproduction  theory  of  valuation  meet  these 
requirements?  Let  us  go  back  a  moment  and  examine 
its  life  history.  Somewhere,  some  time,  a  company  or 
an  individual  owned  a  gas  plant.  I  take  this  for  an 
example  because  it  is  one  of  the  older  utilities. — ^The 
railroad  was  the  first  to  present  the  question  of  valua- 
tion, so  far  as  I  can  determine,  but  it  is  one  of  the  last 
apparently  to  present  a  concrete  case  of  actually 
litigated  valuation.  The  discussion  of  valuation  with 
relation  to  railroads  as  applied  to  rate  controversies  has 
xmtil  quite  recently  been  of  the  most  general  charac- 
ter.— ^The  authorities  in  the  community  served  by  the 
gas  plant  in  question  decided  to  try  to  find  out  whether 
the  owners  of  such  plant  were  charging  more  than  they 
should  for  their  commodity.  By  both  the  public 
authority  and  the  private  owner  it  was  immediately 
agreed  that  the  consumers  of  gas  within  the  community 
could  justly  be  required  to  pay  for  the  operating  cost 
of  the  business;  and  it  was  not  much  harder  to  get  an 
agreement  that  the  amount  of  wear  and  tear  upon  the 
property  should  also  be  taken  care  of  in  the  rates. 
And  then  it  occurred  to  both  that  an  interest  on  the 
value  of  the  property,  as  it  was  called,  also  should  be 
earned.  In  the  early  days  there  was  a  good  deal  of 
talk  of  investment  and  an  earning  upon  investment. 
Today  we  hear  much  less  of  it.  How  to  determine 
this  value  at  the  highest  defensible  amount  was  the 
problem  of  the  owner  of  the  gas  plant.  And  so  he 
looked  about  him  and  quite  naturally  had  presented 
to  him  the  method  of  determining  value  in  ordinary 
transactions  with  which  he  was  acquainted.  Smith 
owned  a  horse  which  he  was  willing  to  sell.  Jones 
desired  to  buy  such  a  horse.  A  neighbor  likewise  had 
a  horse  that  Smith  imagined  might  be  for  sale  at  $150. 
Therefore,  being  desirous  of  selling  his  horse,  he  feared 
if  he  put  his  price  higher  than  $150  Jones  would  buy 


8 


THE      UTILITIES      MAGAZINE 


of  the  neighbor  and  so  $150  was  agreed  upon.  Another 
man  desired  to  buy  a  residence  in  the  town.  One  was 
for  sale.  The  owner  knew  that  the  prospective  pur- 
chaser was  desirous  of  a  residence  immediately.  He 
believed  the  one  he  had  for  sale  was  the  only  one  in 
town  that  would  suit  the  purchaser.  He  knew  that  it 
would  require,  say,  90  days  to  build  a  desirable  resi- 
dence for  the  prospective  purchaser  and  that  such 
property  would  cost  $10,000  to  build.  He  fixed  his 
price  at  $10,000  plus  what  he  thought  the  proposed 
purchaser  would  pay  rather  than  submit  to  the  incon- 
venience of  90  days'  delay,  and  the  sale  was  made. 

Having  in  mind  transactions  such  as  these,  the  owner 
of  the  gas  plant  bethought  himself  of  a  method  of 
determining  the  price  upon  which  the  community 
should  be  required  to  give  him  an  earning  in  his  rates. 
The  gas  property  had  cost  from  the  beginning  in 
amounts  chargeable  to  capital  account  a  half  million 
dollars.  However,  since  the  laying  of  the  mains  the 
Streets  had  been  paved,  also  the  price  of  real  estate 
owned  by  the  company  had  increased  substantially. 
Also,  the  inconvenience  to  the  public  in  doing  without 
gas  for  two  and  a  half  years  during  which  time  another 
plant  could  be  built  would  be  a  large  item.  Further- 
more, the  public  would  be  required  to  be  persuaded 
that  it  needed  to  use  gas  because  the  fact  that  con- 
sumers were  attached  to  the  system  for  which  rates 
were  to  be  fixed  was  of  value  to  the  owner.  Taking 
everything  into  consideration  that  could  possibly  be 
imagined  as  a  disadvantage  to  the  public  of  not  receiv- 
ing gas  from  this  system,  the  engineers  for  the  gas 
company  found  a  price  of  a  million  dollars  to  be  reason- 
able. Now  in  this  case  the  fear  that  the  prospective 
purchasers  of  the  second  gas  plant,  if  it  were  to  be  sold, 
— and  this  was  the  theory  of  the  price  to  be  fixed — 
would  go  to  the  owner  of  a  second  and  competing  gas 
plant  did  not  exist  for  there  was  none  such,  and  under 
our  theory  there  should  be  none  such.  And  the  fear 
of  someone  else  being  permitted  to  build  a  second  plant 
was  not  taken  seriously  because  the  streets  are  now 
paved  and  the  citizens  do  not  desire  to  have  everything 
disturbed  by  the  putting  in  of  a  new  system. 

In  this  supposed  case  every  element  of  threat  price 
that  the  monopoly  character  of  the  enterprise  makes 
possible  is  included,  and  the  reproduction  value  is 
based  upon  what  it  would  cost  another  or  the  govern- 
mental agency  itself  to  build  a  similar  plant  entirely 
independent  of  the  need  of  such  duplicate  plant.  This 
is  the  entire  basis  of  the  reproduction  theory  of  valua- 
tion. The  owners  of  these  properties  have  brought 
themselves  to  that  state  of  mind  that  they  feel  that 
the  price  to  which  they  are  entitled  is  determined  not 
by  what  they  have  sacrificed,  not  by  what  they  have 
done,  but  by  what  they  can  force  the  prospective 


buyer  to  pay.  And  their  theory  grows  up  from  the 
analogy  of  prices  fixed  under  competition  when  their 
prices  can  not  be  fixed  under  competition.  For  our 
main  assumption  is  that  these  agencies  are  and  of  a 
right  ought  to  be,  upon  considerations  of  sound  eco- 
nomics, monopolies;  but  regulation  exists  to  prevent 
monopolies  regulated  from  taking  that  which  monopo- 
lies unregulated  will  surely  take.  And  if  monopolies 
unregulated  do  not  take  more  than  that  to  which  they 
are  entitled,  then  regulation  is  needless  and  not  at  all 
justified. 

But  admitting  the  correctness  of  most  of  the  princi- 
ples we  have  here  discussed,  still  the  monopoly  lawyers 
and  engineers  contend  for  a  system  of  determining 
price  under  the  reproduction  theory  which  is  entirely 
based  upon  an  analogy  with  conditions  existing  under 
competition.  And  taking  advantage  of  this  analogy 
they  urge  that  they  should  be  allowed  to  take  all  that 
the  public  can  be  forced  to  give  rather  than  build  an 
alternative  plant  or  induce  a  second  utility  to  build 
such  alternative  plant.  The  impossibility  of  deter- 
mining a  just  price  in  this  way  seems  to  me  to  be  so 
evident  when  a  monopoly  is  involved  that  I  do  not 
feel  that  argument  is  hardly  necessary.  Yet  these 
utility  owners  continually  clamor  to  be  treated,  with 
reference  to  their  property,  the  same  as  other  people 
are  treated.  To  be  sure  they  have  a  right  to  be  treated 
the  same  as  other  people  are  treated  under  similar 
circumstances,  but  it  is  absolutely  idle  and  vain  for 
them  to  urge  that  the  same  canons  of  valuation,  if  we 
please  to  call  it  by  that  name,  shall  be  adhered  to  in 
their  case  as  we  find  in  competitive  industry.  The 
very  function  of  regulation,  as  I  have  attempted  to 
point  out,  is  to  prevent  the  growing  up  of  values  in 
the  hands  of  the  utility  owners  that  would  result  if 
they  were  permitted  to  determine  such  values  by  the 
same  rules  that  apply  in  competitive  industry.  For 
the  rule  in  competitive  industry,  is  always  to  take  all 
that  can  be  exacted,  but  all  that  can  be  exacted  in  such 
industry  is  limited  by  the  very  competition  to  an 
amount  that  always  tends  to  approximate  the  cost 
price.  The  natural  human  tendencies  are  there  but 
they  are  restrained  and  limited.  In  the  utility,  how- 
ever, all  of  the  important  factors  that  counterbalance 
the  natural  human  selfishness  and  inclination  to  take 
all  that  one  can  get  are  lacking,  and  since  we  are  com- 
mitted to  the  maintenance  of  these  agencies  as  monopo- 
lies such  limiting  factors  will  permanently  be  lacking. 

There  are  two  absolute  bars  to  the  application  of  the 
reproduction  theory  of  valuation  to  utilities.  The  one 
is  the  impossibility  of  imagining  the  monopoly  never 
to  have  existed  and  the  conditions  which  such  monopoly 
has  produced  still  there;  of  thinking  the  effect  of  a 
certain  known  cause  and  at  the  same  time  conceiving 


THE      REPRODUCTION      THEORY 


9 


such  cause  never  to  have  operated.  The  other  is  the 
impossibility  of  thinking  monopoly  and  competition  at 
the  same  time;  the  impossibility  of  having  the  condi- 
tion of  the  property  of  a  monopoly  affected  by  a 
duplicate  competing  agency  and  still  remain  unchanged. 
Justice  Hughes  discusses  the  first  difficulty  in  the 
Minnesota  Rate  Case  (Simpson  vs.  Shepard,  230  U.  S. 
352).     He  there  says: 

"Moreover  it  is  manifest  that  an  attempt  to  estimate  what 
would  be  the  actual  cost  of  acquiring  the  right  of  way  if  the 
railroad  were  not  there  is  to  indulge  in  mere  speculation. 
The  railroad  has  long  been  established;  to  it  have  been  jinked 
all  activities  of  agriculture,  industry  and  trade.  Communi- 
ties have  long  been  dependent  upon  its  service,  and  their 
growth  and  development  have  been  conditioned  upon  the 
facilities  it  has  provided.  The  uses  of  property  in  the  com- 
munities which  it  serves  are  to  a  large  degree  determined  by 
it.  The  values  of  property  along  its  line  largely  depend  upon 
its  existence.  It  is  an  integral  part  of  the  communal  life. 
The  assumption  of  its  non-existence  and  at  the  same  time 
that  the  values  that  rest  upon  it  remain  unchanged  is  impos- 
sible and  can  not  be  entertained.  The  conditions  of  owner- 
ship of  the  property  and  the  amounts  which  would  have  to 
be  paid  in  acquiring  the  right  of  way  supposing  the  railroad 
to  be  removed  are  wholly  beyond  reach  of  any  process  of 
rational  determination.  The  cost-of -rep reduction  method  is 
of  service  in  ascertaining  the  present  value  of  the  plant  when 
it  is  reasonably  applied  and  when  the  cost  of  reproducing 
the  property  may  be  ascertained  with  a  proper  degree  of 
certainty." 

Those  urging  the  reproduction  theory  to  determine 
the  price  upon  which  an  earning  shall  be  allowed  are 
confronted  with  a  very  interesting  dilemma.  If  their 
theory  is  to  deal  with  the  very  property  in  question  as 
a  monopoly,  they  cannot,  as  Justice  Hughes  points  out, 
think  it  away  and  at  the  same  time  have  the  results 
that  come  from  its  presence.  On  the  other  hand,  if  it 
is  an  alternative  proposition  which  they  urge  and  the 
thing  which  they  have  a  right  to  exact  is  that  which 
the  public  or  a  competitor  would  have  to  pay  to  put  in 
a  second  plant  identical  with  their  own,  they  have  to 
be  confronted  with  the  results  of  such  duplication  and 
they  come  face  to  face  with  the  thing  I  have  had  in 
mind  from  the  beginning,  namely,  the  threat  power  of 
the  public.  Owners  of  public  utility  property  would 
never  for  a  moment  contend  for  the  reproduction  theory 
if  they  thought  the  public  would  take  them  at  their 
word.  For  as  far  as  price  is  concerned  under  this 
theory  it  is  utterly  immaterial  to  the  public  whether 
they  buy  the  existing  utility  property  or  leave  it  there 
and  proceed  to  duplicate  it.  For  do  not  the  propo- 
nents of  this  theory  seek  to  capitalize  not  only  the 
physical  property,  but  every  known  disadvantage  to 
the  public,  such  as  paving  over  mains,  for  example, 
and  every  known  or  imagined  advantage  to  themselves 


such  even  as  having  consumers  attached  to  the  system, 
if  you  please?  And  they  place  their  reliance  on  one 
thing  alone  and  that  is  that  the  public  if  they  should 
build  a  competing  utility  in  this  field  would  lose  money 
because  of  the  dividing  up  of  the  business.  On  this 
they  pin  their  hope  when  they  pile  Ossa  on  Pelion  in 
piling  up  the  items  with  which  the  public  shall  be  taxed. 
By  what  license  do  they  forget  that  the  loss  of  business 
by  duplication  will  fall  on  them  too?  If  they  take  the 
horn  of  the  dilemma  which  supposes  a  property  to 
remain  in  place  and  the  values  produced  by  the  very 
monopoly  itself  and  by  reason  of  its  being  a  monopoly, 
and  assume  the  building  by  the  public  or  a  competitor 
of  a  second  system  identical  with  their  own,  then  they 
have  in  fact  not  imagined  the  monopoly  out  of  exist- 
ence, but  put  it  out  of  existence.  Thus  they  are  left 
to  choose  whether  they  are  merely  theorizing  or  specu- 
lating, as  Justice  Hughes  calls  it,  on  things  that  might 
exist  if  other  things  that  do  exist  did  not  exist,  and 
are  so  adopting  the  method  that,  as  the  learned  Justice 
points  out,  has  no  rational  basis,  or  are  prepared  to 
justify  in  good  faith  their  threat  and  to  accept  the 
results  thereof  and  be  ready  to  meet  the  emergency 
which  would  arise  if  the  public  exerted  its  threat  power 
too  and  took  them  at  their  word  and  built  a  second 
plant.  How  they  would  complain  and  how  they  do 
complain  at  the  mere  thought  of  such  an  injustice! 
But  it  is  upon  the  theory  alone  that  the  public  might 
do  this  very  thing  that  they  can  justify  the  threat  price 
which  the  reproduction  theory  contains.  Are  the  util- 
ity owners  any  more  justified  in  contending  that  the 
just  price  is  determined  by  the  answer  to  the  question, 
"How  much  can  we  force  them  to  pay  rather  than  go 
elsewhere?"  when  there  is  nowhere  else  to  go,  than  the 
public  would  be  in  asking,  "How  little  can  we  force 
them  to  take  rather  than  be  ruined?"  One  is  certainly 
no  more  devoid  of  equity  and  justice  than  the  other. 
They  are  both  threats  alike.  If  in  every  case  the  pub- 
lic took  up  the  challenge  and,  instead  of  paying  a  rate 
upon  the  value  for  which  this  method  contends,  built  a 
competing  property,  the  price  at  which  the  utility 
would  sell  its  property  would  certainly  be  very  sub- 
stantially affected. 

I  might  go  into  the  various  phases  of  the  reproduc- 
tion method,  but  time  will  not  permit.  The  incon- 
sistency of  adopting  the  historical  method  with  refer- 
ence to  some  elements  and  rejecting  it  with  reference 
to  some  others  need  only  be  mentioned.  Why  it  is 
that  the  committee  of  presidents  of  the  railroads  of 
the  United  States  should  concern  themselves  with 
hidden  costs  of  some  elements  of  the  properties  of  the 
railroads  and  forget  all  about  hidden  or  other  costs  of 
lands  and  properties  that  have  appreciated,  is  beyond 
my  comprehension. 


10 


THE      UTILITIES      MAGAZINE 


I  really  seriously  wonder  at  the  logic  of  those  who 
urge  that  cost  shall  ever  have  anything  to  do  with  this 
question  unless  they  admit  it  has  everything  to  do  with 
it,  and  I  marvel  at  their  regard  for  the  simplicity  of 
public  authority  when  they  urge  that  original  cost  shall 
always  be  used  even  in  their  reproduction  theory  when 
it  will  give  them  more  than  present  cost  to  reproduce, 
and  at  the  same  time  utterly  repudiate  costs  of  lands 
and  similar  properties  when  such  costs  are  less  than  the 
market  value  now  obtained.  I  do  not  for  a  moment 
contend  that  the  work  of  the  engineers  in  making  in- 
ventories, and,  if  you  please,  in  fixing  unit  prices  is 
not  very  important.  But  holding,  as  I  do,  that  where 
government  is  dealing  with  monopoly  it  of  necessity 
must  deprive  such  monopoly  of  the  power  of  taking  all 
that  it  can  get  from  its  patrons,  I  am  driven  to  conclude 
that  government  must  determine  as  a  substitute  what 
the  agency  ought  to  take,  and  in  determining  what  the 
agency  ought  to  take  the  safest  and  most  just  guide  is 
what  the  agency  has  sacrificed  and  what  service  it  has 
performed  for  the  public.  If  we  had  this  problem  at 
the  beginning  and  were  not  attacking  it  in  the  middle, 
we  would  have  no  difficulty  in  agreeing  with  the  holder 
of  capital  upon  this  subject,  for  he  would  quite  readily 
agree  to  take  the  cost  of  doing  the  business  plus  an 
earning  upon  the  money  actually  invested  comparable 
to  the  earning  offered  in  other  available  investments. 
Therefore,  the  cost  of  doing  the  business  plus  a  return 
upon  the  capital  necessarily  invested  in  the  business, 
which  return  shall  be  as  great  as  is  offered  in  other 
businesses  of  similar  hazard,  is  all  that  ought  to  be 
accorded  for  the  future  and  it  is  ,all  that  will  be  ac- 
corded if  the  public  has  any  business  sense.  And  if 
more  is  asked  by  the  private  owner,  then  he  may  expect 
no  sympathy  when  he  finds  the  public  his  competitor 
and  his  earning  power  impaired.  The  inventories  and 
the  reproduction  information  are  very  valuable  because 
unfortunately  it  is  always  very  difficult  to  determine 
the  actual  investment  and  determine  the  amount  upon 
which  an  earning  ought  to  be  permitted  because  the 
original  evidence  is  so  often  lost.  Therefore,  while  we 
resort  to  investigations  looking  to  original  cost,  still  we 
may  likewise  avail  ourselves  of  expert  engineering  advice 
as  to  what  the  property  ought  to  have  cost,  and  the  his- 
torical method  of  reproduction  is  extremely  valuable 
in  supplying  secondary  evidence  when  the  primary 
evidence  is  lost. 

In  these  engineering  quests,  however,  great  care 
should  be  exercised  to  the  end  that  findings  shall  only 
be  made  by  the  engineers  upon  questions  of  fact.  The 
proper  amoimt  upon  which  the  utility  should  be  per- 
mitted to  earn  in  each  case,  being  an  amount  which  is 
determined  as  the  result  of  the  judgment  of  the  gov- 
ernmental authority  empowered  to  act,  should  always 


be  reserved  for  such  determination.  For  an  engineer  of 
a  public  utility  company  or  representing  the  state  as 
a  witness  where  this  question  is  to  be  determined,  to 
state  that  the  "value"  of  the  property  involved  is  a 
definite  sum, — meaning  the  price  upon  which  an  earn- 
ing should  be  allowed— is  for  such  engineer  to  usurp 
the  function  of  the  governmental  tribunal  before  which 
he  testifies.  In  determining  this  amount,  which  is  the 
thing  that  all  should  necessarily  desire  to  know,  all  of 
the  facts,  historical  and  otherwise,  all  of  the  engineer- 
ing data,  all  of  the  accounting  data,  and  everything 
that  can  be  learned  about  the  enterprise  in  question 
should  be  considered. 

Some  of  my  engineering  friends  have  criticized  me 
because  they  say  that  I  do  not  suggest  a  definite  plan 
of  universal  application  for  determining  the  "value" 
of  the  property.  I  contend  that  the  method  here  urged 
is  the  only  one  that  can  be  followed  if  we  have  in  mind 
the  nature  of  the  problems  to  which  we  address  our- 
selves. For  any  one  to  lay  down  a  set  of  rules  apph- 
cable  in  every  case  for  determining  this  question  is  an 
impossibility  and  always  will  be  so  far  as  existing  enter- 
prises are  concerned.  As  to  the  future,  however,  a 
liberal  return  upon  the  investment  actually  made  would, 
in  my  opinion,  be  all  that  is  justified.  Such  a  return 
should  be  sufficient  to  induce  the  man  with  money, 
knowing  what  it  will  be  in  advance,  to  make  the  in- 
vestment. 

It  is  not  by  way  of  criticism  that  I  call  attention  to 
the  program  of  the  utilities  today.  They  are  merely 
following  a  natural  business  course,  shortsighted,  how- 
ever, in  my  opinion,  if  the  public  is  awake.  Today 
the  Interstate  Commerce  Commission  is  engaged  under 
an  act  of  Congress  in  collecting  data  concerning  the 
railroads  of  the  United  States.  The  railroads  quite 
naturally  are  attempting  to  determine  the  lines  upon 
which  the  inquiry  shall  be  prosecuted,  and  the  results 
that  shall  be  obtained.  I  have  confidence  in  those 
directing  this  valuation,  and  I  have  no  fear  that  they 
will  not  do  all  in  their  power  to  secure  the  information 
fairly  and  make  their  determinations  intelligently  and 
fearlessly.  But  the  fact  that  tremendous  sums  are 
being  expended  by  the  representatives  of  the  railroads 
in,  as  I  have  already  suggested,  hunting  for  hidden 
quantities  and  the  like  and  in  seeking  in  every  way  in 
their  power  to  affect  the  determination  of  this  question 
in  a  way  favorable  to  themselves,  should  put  the  public 
on  guard  lest  their  side  be  not  properly  presented.  I 
have  no  hesitancy  in  saying  that  it  is  my  belief  that  if 
the  Interstate  Commerce  Commission  should  adopt  the 
reproduction  theory  of  valuation  as  the  proper  price 
upon  which  the  railroads  should  be  permitted  an  earn- 
ing,— which  would  ultimately  determine  the  price  which 
the  public  would  be  required  to  pay  for  these  roads 


THE      REPRODUCTION      THEORY 


11 


if  public  ownership  should  prevail, — a  result  will  be 
produced  which  will  make  it  necessary  for  the  public  to 
resort  to  its  threat  power  and  compete  with  these  agen- 
cies until  they  shall  be  of  a  reasonable  mind. 

As  I  have  already  suggested,  it  is  just  as  logical  for 
the  public  to  say  to  the  railroads  and  the  other  public 
utilities,  "How  low  can  we  force  you  to  fix  your  price 
rather  than  for  us  to  destroy  or  impair  your  property 
by  competition,"  as  it  is  for  these  agencies  to  say,  "How 
high  can  we  force  you  to  pay  rather  than  build  your 
own  facilities."  Much  scoflfing  is  indulged  in  by  some 
of  our  railroad  friends  when  we  speak  of  the  public 
ownership  of  these  lines  and  the  danger  to  them  of  pub- 
lic competition.  The  same  kind  of  scoflfing  was  indulged 
not  so  many  years  ago  by  other  utilities  on  the  same 
subject,  but  in  my  experience  on  the  Railroad  Com- 
mission of  California  I  have  seen  at  least  two  instances 
where  the  public  has  competed  out  of  existence  and 
reduced  to  junk  water  systems  privately  owned.  Do 
not  for  a  moment  understand  me  as  advocating  con- 
fiscation, legal  though  it  may  be.  I  am  merely  trying 
to  analyze  the  conditions,  and  I  would  utter  this  note 
of  warning.  Liberal  treatment  ought  always  to  be 
given  by  the  public  to  those  agencies  conducting  them- 
selves in  such  a  manner  as  to  demonstrate  their  inten- 
tion to  be  fair,  but  the  suppression  of  facts,  the  dis- 
tortion of  evidence,  the  exaggeration  of  values  and  the 
seeking  after  new  and  ridiculous  intangibles  can  have 
but  the  result  of  making  the  public  forgetful  of  the  real 
equities  and  the  just  claims  of  these  enterprises.  Their 
engineers  have  already  consciously  and  outrageously 
exaggerated  their  values,  and  none  know  it  better  than 
they.  They  have  brought  about  a  condition  where  the 
engineers  who  desire  to  present  the  real  conditions  are 
almost  afraid  to  do  so,  and  their  fear  is  more  or  less 
justified.  I,  myself,  have  discussed  this  question  with 
many  of  them,  and  they  say  it  is  the  custom  of  com- 
missions always  to  cut  valuations  submitted;  and, 
therefore,  if  they  submit  the  figures  upon  which  they 
expect  to  rely,  these  will  be  cut,  too.  On  the  other 
hand,  utility  commissioners,  conscious  of  the  adroitness, 
the  ability  and  the  great  shrewdness  of  these  intensely 
intelligent  experts  employed  at  high  salaries  by  the 
big  utilities,  and  feeling  that  they  have  submitted  the 
highest  that  they  could  justify  under  any  circumstances 
to  the  most  credulous,  and  too  often  recognizing  their 
own  inability  and  lack  of  facility  to  learn  the  true  facts, 
are  inclined  to  cut  all  valuations  submitted.  Thus 
practically  an  impasse  has  been  created  due  very  largely 
to  the  foolishness  and  shortsightedness  of  those  who  do 
not  respect  the  intelligence  of  public  authority,  and 
likewise  due  to  the  fact  that  sometimes  public  author- 
ity isjnot  worthy  of  respect.  This  condition^shows 
those  representing  the  public  and  those  representing 


the  utilities  who  desire  only  an  honest  determination 
of  these  great  questions,  the  work  that  must  be 
done.  We  must  first  get  into  the  minds  of  those  in 
control  of  public  utilities  the  understanding  that  the 
public  will  not  be  exploited  and  we  should  induce  in 
those  among  them  who  are  honest  (and  I  am  glad  to 
say  they  have,  by  my  experience,  been  shown  to  be 
largely  in  the  majority)  the  spirit  of  co-operation  and 
fair  play  which  leads  them  to  present  their  facts  just 
as  they  are  and  not  distort  them;  and,  on  the  other 
hand,  we  should  seek  to  have  as  representatives  of 
the  public  only  those  who  are  fair-minded  enough  to 
desire  to  do  right  and  intelligent  enough  to  know  how 
to  do  it. 

I  have  several  times  here  indicated  my  belief  in  a 
somewhat  different  rule  for  the  future  than  the  past. 
I  am  free  to  confess  that  the  proper  treatment  of  the 
existing  utility  has  given  me  much  bother.  This  is 
due  to  innocent  third  party  contention.  Now  I  know 
this  is  overworked  and  I  know  too  that  the  concern 
for  the  widow  and  orphan  investor  is  often  a  feigned 
concern,  but  we  must  all  admit  that  the  public  is  in 
part  at  fault  for  permitting  things  to  be  lawfully  done 
in  the  past  that  were,  except  for  such  legal  sanction, 
at  least  questionable.  I  have  contended  for  equitable 
considerations.  For  the  future  we  must  hold  out  that 
inducement,  so  long  as  we  have  private  ownership  of 
utilities,  which  the  investor  is  willing  to  accept.  Our 
alternative  necessarily  must  be  public  ownership.  Man- 
ifestly public  authority  can  not  in  conscience  withdraw 
or  lessen  the  inducement  after  the  investment  is  made. 
Just  so  as  to  the  past  we  should  accord  that  treatment 
to  the  investor  which  he  had  a  right  lawfully  to  expect 
and  should  if  possible  of  determination  accord  to  him 
that  amount  which  is  the  minimum  which  would  have 
induced  the  investment  could  it  have  been  known  in 
advance. 

I  recognize  the  very  general  character  of  the  rule  I 
suggest  but  of  necessity  it  must  be  general.  For  the 
future  always  the  cost  of  doing  the  business  should  be 
the  aim.  Of  course  in  this  will  be  included  every  legit- 
imate element  of  cost.  Always  such  cost  must,  as  I 
said  here  a  year  ago,  stand  the  comparison  with  costs 
under  publicly  owned  utilities.  For  the  past  we  should 
allow  such  a  basis  for  earning  as  equitable  considera- 
tions warrant,  never  enhanced  because  the  agency  is 
a  monopoly  and  determined  in  view  of  all  the  facts 
that  can  be  ascertained.  In  marshalling  these  facts 
the  work  of  the  engineer  in  determining  quantities  and 
unit  costs  as  bearing  upon  what  the  property  should 
have  cost  under  ascertained  conditions  and  the  work 
of  the  accountant  in  analyzing  actually  located  expen- 
itures  are  but  complements  to  each  other.  Each  is 
extremely  important  but  neither  alone  under  the  con- 


12 


THE      UTILITIES      MAGAZINE 


ditions  under  which  utilities  have  been  conducted  in 
the  past,  sufficient  finally  to  solve  our  problem. 

I  conclude  that  as  far  as  the  past  is  concerned  it  is 
impossible  to  know  in  any  case  that  we  have  done  abso- 
lute justice  in  valuing  utility  property,  but  I  contend 
we  may  be  assured  within  reasonable  limits  in  any 


given  case  provided  there  is  co-operat'on  by  all  con- 
cerned in  attempting  to  reach  the  just  and  fair  result. 
But  I  am  quite  sure  that  the  cost  of  reproduction 
method  as  now  being  used,  or  rather  abused,  is  getting 
us  further  from  the  solution  of  our  problem  rather  than 
nearer  to  it. 


REPRODUCTION  VALUE  VS.  FAIR  VALUE 

By  H.  Findlay  French 

Attorney  at  Law,  Baltimore,  Md. 


IT  HAS  been  said  that  though  the  Constitution  of 
the  United  States  is  great  in  what  it  expressly 
sets  forth,  yet  it  is  infinitely  greater  in  what  it 
leaves  to  interpretation.  In  like  manner  the  decisions 
of  the  Supreme  Court  of  the  United  States  upon  the 
subject  of  the  fair  value  of  the  property  of  public 
utilities,  while  great  in  what  they  expressly  set  forth, 
are  infinitely  greater  in  what  they  leave  to  the  sound 
judgment  and  discretion  of  courts  and  public  utility 
commissions. 

In  theory,  fair  value  to  the  public  and  fair  value  to 
the  utility  are  one  and  the  same.  In  actual  practice, 
however,  what  the  utility  considers  fair  to  itself,  the 
public  considers  extortion,  and  what  the  public  con- 
siders fair  to  itself,  the  utility  considers  confiscation. 
Under  these  conditions  it  is  the  special  province  and 
duty  of  public  service  commissions  to  reach  an  equi- 
table mean  between  these  two  points  of  view  after  first 
having  carefully  weighed  the  contentions  of  either  side. 
How,  therefore,  as  a  practical  matter,  can  a  proper 
balance  be  struck  between  the  contending  parties,  and, 
as  a  practical  matter,  how  shall  fair  value  be  weighed 
and  with  what  scales? 

The  Supreme  Court  has  answered  these  questions  as 
completely  and  conclusively  as  it  has  ever  answered 
any  questions  coming  before  it  for  final  determination. 
It  has  frequently  reaffirmed  that  answer,  and  the 
answer  is  this:  The  scales  to  be  used  by  courts  and 
public  service  commissions  in  reaching  a  correct  balance 
between  the  contentions  of  the  public  on  the  one  hand 
and  the  contentions  of  the  public  utility  on  the  other 
hand,  must  be  of  such  a  character  as  to  provide  a  place 
for  the  original  cost  of  construction,  for  the  amount 
expended  in  permanent  improvements,  for  the  amount 
and  market  value  of  the  bonds  and  stock,  for  the  present 
as  compared  with  the  original  cost  of  construction,  for 
the  probable  earning  capacity  of  the  property  under 
particular  rates  prescribed  by  statute,  for  the  sum  re- 
quired to  meet  operating  expenses,  and  for  all  such 
other  matters  as  may  be  necessary  to  be  considered  in 


arriving  at  an  equitable  decision.  So  much  for  the 
scales  upon  which  the  balance  is  to  be  struck.  As  to 
the  method  to  be  employed  in  using  these  scales,  this  is 
left,  as  it  should  be  left,  to  the  sound  judgment  and 
discretion  of  each  commission,  so  that  such  weight 
may  be  given  to  each  of  the  above  enumerated  elements 
as  may  be  fair,  just  and  right  in  each  particular  case. 

WHAT  IS  REPRODUCTION  VALUE? 

The  subject  of  this  paper  concerns  itself  with  one 
of  these  methods  of  valuation  which  under  the  rulings 
of  the  Supreme  Court  must  be  taken  into  consideration. 
This  method  is  known  as  the  reproduction  cost  method, 
and  the  final  figures  resulting  from  the  use  of  this 
method  may  be  termed  the  reproduction  value  of  the 
property.  In  short,  it  is  an  estimate  of  the  number  of 
dollars  which  it  would  be  necessary  to  expend  at  the 
present  time  and  at  the  present  prices  of  labor  and 
materials  to  produce,  in  an  assumed  period  of  years, 
the  present  identical  property,  together  with  its  present 
identical  business.  From  many  points  of  view,  it 
would  almost  seem  surplusage  to  discuss  whether  an 
estimate  of  the  cost  at  the  present  time  to  produce  an 
identical  plant  with  its  identical  business  in  a  hypo- 
thetical period  can  ever  represent,  except  by  mere 
chance,  the  fair  value  of  the  property  of  a  public  utility. 
But  continued  efforts  on  the  part  of  certain  utilities  to 
obtain  a  high  valuation  for  their  properties  through  the 
use  of  the  reproduction  cost  method  may  unconsciously 
affect  the  action  of  public  service  commissions  unless 
representatives  interested  in  the  rights  of  the  public 
are  equally  conscientious  in  continuing  not  only  to 
point  out,  but  also  to  reiterate,  the  unfairness  of  this 
method. 

TWO  KINDS  OF  VALUE 

For  the  purpose  of  the  present  discussion,  let  us 
consider  first  whether  reproduction  value  is  value  in 
•its  commonly  accepted  sense.  Now  value  may  mean 
one  of  several  things.     In  the  ordinary  acceptation  of 


THE      REPRODUCTION      THEORY 


13 


the  word  value  signifies  exchange  value.  As  a  business 
proposition,  the  value  of  a  horse,  or  of  a  house,  or  of  a 
pound  of  sugar,  is  the  amount  of  money  that  it  can  be 
sold  for.  Again,  value  may  be  used  to  mean  fair 
value  for  rate  making  purposes,  or,  as  it  may  be  called, 
rate  value.  While  there  are  several  other  types  of 
value,  it  is  sufficient  for  the  purposes  of  this  paper  to 
comment  merely  on  the  two  kinds  of  value  above 
mentioned. 

Before  discussing  reproduction  value  in  connection 
with  fair  value,  it  may  not  be  out  of  place  to  point  out 
that  the  reproduction  cost  method  does  not  arrive  at 
the  figures  which  express  in  dollars  the  value  with  which 
all  of  us  are  most  familiar,  viz. :  exchange  value.  It  is 
worth  while  to  do  this  for  the  reason  that  there  may 
be  a  subconscious  feeling  that  while  the  reproduction 
cost  method  may  not  produce  results  which  can  be 
called  fair  value,  yet  that  it  does  produce  results,  which, 
were  it  not  for  the  equities  of  the  public,  would  repre- 
sent, irrespective  of  monopoly,  proper  and  tangible 
values  in  the  ordinary  business  world.  Quite  the 
opposite  is  the  case. 

REPRODUCTION  VALUE  DOES  NOT  REPRE- 
SENT EXCHANGE  VALUE 

Adverting,  then,  for  a  moment  to  exchange  value, 
which,  after  all  is  said  and  done  expresses  completely 
the  ordinary  meaning  of  the  word  "value,"  we  can  see 
almost  at  a  glance  that  the  reproduction  cost  method 
does  not  arrive  at  a  figure  which  represents  this  kind  of 
value. 

Take,  for  illustration,  an  automobile  purchased  five 
years  ago,  and  still  rendering  reliable  service.  As  a 
practical  matter,  the  original  cost  of  the  automobile 
certainly  has  nothing  to  do  with  its  present  value,  but 
neither  has  the  reproduction  cost.  An  estimate  of  the 
cost  of  reproducing  the  identical  automobile  with  all 
its  identical  parts  would  certainly  not  represent  its 
value  at  the  present  time.  This  is  so  for  the  reason 
that  its  value  would  depend  not  on  the  reproduction 
cost  of  the  identical  machine,  but  the  cost  today  of  a 
machine  perhaps  of  an  entirely  different  type,  which 
would  render  equally  efficient  service.  This  exact 
point  in  question  was  recognized  in  a  recent  valuation 
case  in  Maryland  where  the  reproduction  cost  of  certain 
obsolete  telephone  instruments  still  in  use  was  displaced 
by  an  estimate  of  the  cost  of  replacing  these  obsolete 
telephone  instruments  with  modern  telephone  instru- 
ments. But  no  attempt  was  made  in  this  case,  or  so 
far  as  I  can  learn,  no  serious  attempt  has  ever  been 
made  in  any  other  important  case  to  apply  this  measure 
to  the  entire  plant,  and  thus  to  estimate  the  cost  of 
putting  in,  not  a  duplicate  plant,  but  a  plant  located 
along  the  most  economic  lines,  taking  into  considera- 


tion every  present  condition.  I  allude  to  this  failure 
not  by  way  of  suggesting  that  true  reproduction  cost 
should  consist  of  an  estimate  of  the  cost  of  the  most 
efficient  and  economic  plant  which  could  be  constructed 
under  prevailing  conditions,  but  rather  to  point  out 
that  the  present  method  of  arriving  at  reproduction 
cost  results  in  a  figure  which  is  not  value  in  the  ordinary 
sense  of  the  word. 

In  a  public  utility  plant  which  possesses  all  types 
and  classes  of  property  bought  or  constructed  at  sundry 
times  during  the  life  of  the  utility,  the  reproduction 
cost  method,  as  commonly  applied,  must  and  does 
regularly  produce  results  in  favor  of  the  company  such 
as  no  other  private  company  or  business  can  possibly 
obtain.  The  private  company  must  meet  the  competi- 
tion not  of  an  identical  plant  in  an  identical  location, 
but  the  competition  of  the  most  efficient  plant  at  the 
most  efficient  location.  The  public  utility,  however, 
in  the  valuation  of  its  property  along  reproduction 
lines,  gets  credit  for  each  portion  of  its  property  upon 
the  basis  that  each  portion  is  the  most  efficient  which 
could  be  devised  at  the  present  time.  This  is  in  itself 
an  absurd  proposition  for  it  carries  with  it  as  a  neces- 
sary corollary  that  human  hindsight  is  no  whit  better 
than  human  foresight.  Public  utility  attorneys  try 
to  impress  courts  and  commissions  with  the  fact  that 
the  reproduction  cost  of  their  properties  is  the  cost 
which  the  public  would  have  to  expend  today  to  obtain 
the  existing  service.  This  contention  is  clearly  falla- 
cious, because  it  leaves  out  of  consideration  the  fact 
that  the  cost  today  of  constructing  a  public  utility 
property  insuring  equal  service  and  efficiency  is  certain 
to  be  lower  than  the  cost  of  reproducing  the  identical 
plant  now  in  existence. 

Another  reason  why  the  reproduction  value  of  the 
physical  plant  does  not  represent  exchange  value  lies 
in  the  fact  that  this  reproduction  estimate  will  be 
exactly  the  same  when  applied  to  a  plant  which  is 
rapidly  losing  money,  as  it  would  be  to  a  successful 
plant  which  is  earning  large  dividends.  In  each  case 
the  cost  of  reproducing  the  plant  would  be  the  same, 
but  its  value  as  a  plant  would  be  absolutely  and  totally 
different.  Moreover,  this  difference  under  the  repro- 
duction method  would  be  necessarily  disregarded  as  if 
it  was  non-existent.  This  fact  standing  alone  would 
be  sufficient  to  prohibit  reproduction  value  from  being 
considered  value  in  the  ordinary  sense  of  the  word. 

REPRODUCTION  VALUE  DOES  NOT  REPRE- 
SENT FAIR  VALUE 

Having  pointed  out  as  briefly  as  possible  two  funda- 
naental  reasons  why  reproduction  cost  as  now  employed, 
cannot,  except  by  chance,  produce  a  result  which  can 
be  tagged  exchange  value,  let  us  consider  for  a  moment 


14 


THE      UTILITIES      MAGAZINE 


some  of  the  criticisms  of  the  reproduction  method 
which  are  applicable  when  fair,  or  rate  value  is  the 
object  of  the  inquiry. 

As  far  as  the  cost  of  reproduction  of  the  identical 
plant  is  concerned,  this  cost  is  not  in  some  respects  so 
distant  from  fair  value  as  it  is  from  exchange  value. 
There  is  a  distinct  element  of  fairness  in  allowing  a 
utility  credit  for  its  entire  existing  plant  where  this 
plant  has  been  constructed  from  time  to  time  in  a 
reasonably  efficient  manner.  If,  however,  the  utility 
is  to  be  allowed  full  value  for  every  item  of  plant  in 
disregard  of  the  fact  that  a  more  economic  and  efficient 
one  could  be  constructed  at  the  present  time,  then  there 
are  also  equities  in  favor  of  the  public,  such  as  actual 
costs  of  rights  of  way,  land,  etc.,  which  should  be  taken 
into  consideration.  In  valuation  cases,  however,  the 
utility  is  apt  to  insist  not  only  upon  the  reproduction 
cost  of  the  identical  plant,  but  also  upon  the  strict  re- 
production cost  as  applied  both  to  land  and  to  rights  of 
way.  If  equities  in  favor  of  a  utility  are  to  be  consid- 
ered, equities  in  favor  of  the  public  must  likewise  be 
considered. 

THE  RISING  COST  OF  LABOR 

Again  under  the  reproduction  method,  as  applied,  the 
calculations  are  based  upon  the  costs  of  labor  and 
materials  as  they  exist  today.  It  is  well  known  that 
these  costs  have  been  steadily  rising  for  years,  and  that 
therefore  the  values  obtained  by  this  method  are  almost 
certain  to  be  higher  than  the  actual  costs  incurred  by 
the  public  utility.  This  criticism  is  really  one  which, 
while  it  effects  the  public  adversely  at  the  present  time, 
might  easily  be  one  that  some  time  or  other  might 
return  to  plague  the  inventor.  It  would  not  seem  fair 
to  the  public  utility,  if  costs  of  labor  and  supplies  had 
gone  down  rapidly  in  the  past  ten  years,  to  state  arbi- 
trarily that  the  value  of  its  property  devoted  to  public 
use  had  decreased  in  equal  amount.  It  likewise  does 
not  seem  fair  to  the  public  to  raise  the  value  of  the 
public  utility's  property  for  the  reason  that  costs  have 
risen.  To  carry  this  plan  to  its  logical  conclusion,  it 
would  be  necessary  to  change  the  value  of  the  property 
of  public  utility  companies  each  time  that  there  was  a 
fluctuation  in  the  prices  of  labor  and  materials,  and 
such  a  change  would,  of  course,  lead  to  unstable  and 
undesirable  conditions. 

RIGHTS  OF  WAY  AND  PAVEMENT 

In  regard  to  rights  of  way,  pavement  over  mains, 
etc.,  the  regular  reproduction  method  clearly  results  in 
figures  which  have  no  practical  relation  to  fair  value 
at  all.  This  was  demonstrated  in  the  Minnesota  Rate 
Case  where  the  claim  for  reproduction  values  for  rights 
of  way  was  held  to  be  based  upon  mere  conjecture 


impossible  of  rational  ascertainment;  and  in  the  recent 
Des  Moines  Gas  Case  where  reproduction  values  for 
pavement  over  mains  were  disallowed.  That  utility 
companies  should  make  vigorous  and  persevering  efforts 
to  base  claims  for  value  upon  the  fact  that  the  tax- 
payers in  cities  and  towns  have  expended  large  sums 
of  money  to  acquire  modern  pavements,  which  would 
have  to  be  in  part  torn  up  and  relaid  were  their  prop- 
erties reconstructed  under  the  reproduction  theory,  a 
condition  which  has  not  occurred  and  which  cannot 
occur,  shows  to  what  lengths  efforts  are  made  to  con- 
form to  an  exorbitant  theory  of  value. 

INTANGIBLES 

Thus  far  my  remarks  have  been  confined  to  the 
important  difference  existing  between  reproduction 
value,  exchange  value  and  fair  value  as  applied  to  the 
actual  physical  plant.  When,  however,  we  come  to 
the  subject  of  intangibles,  which  is  always  the  most 
difficult  problem  met  with  in  the  valuation  of  public 
utilities,  we  find  that  any  estimate  of  the  cost  of  repro- 
ducing the  present  business  at  the  present  time  must 
be  from  the  very  nature  of  the  case  little  more  than  a 
mere  guess.  This  is  due  to  the  fact  that  there  are  so 
many  assumptions  involved  that  the  incorrectness  of 
any  of  them  might  not  only  entirely  alter  the  result 
obtained,  but  even  make  any  result  impossible  of  attain- 
ment. When  the  chief  engineer  of  the  Bell  Telephone 
Company  of  Pennsylvania  was  asked,  referring  to  the 
reproduction  metliod  used  in  a  valuation  case  involving 
that  company's  entire  property  in  the  State  of  Penn- 
sylvania, "Now,  as  a  matter  of  fact  no  one  would 
construct  under  the  conditions  you  have  assumed" 
his  answer  was,  "Oh,  no."  If  no  one  would  construct 
a  plant  under  the  conditions  assumed  by  the  reproduc- 
tion method,  it  is  doubly  true  that  no  one  would  ever 
attach  the  business  of  the  company  under  the  numerous 
assumptions  necessary  in  working  out  the  result  ob- 
tained under  the  reproduction  method.  While  such  a 
method  is  ingenious  as  applied  to  so-called  organization 
and  development  expense,  it  is  fantastic  in  the  extreme. 

REPRODUCING  A  TELEPHONE  BUSINESS  IN 

1914 

Dr.  Edward  W.  Bemis  in  testifying  in  the  case  re- 
ferred to  gave  a  vivid  picture  of  theoretical  reproduction 
in  the  year  1914  of  the  Bell  Telephone  Company's 
present  organization: — 

"Q.  In  any  estimate  of  cost  to  reproduce  a  property,  do 
you  recognize  an  element  of  organization  and  development? 

"A.  On  the  reproduction  theory  you  do  have  that. 

"Q.  How  can  you  most  easily  arrive  at  that? 

"A.  By  estimating  generally  that  a  plant  is  entirely 
blotted  out;  that  the  people  have  no  telephone  utility,  for 


THE      REPRODUCTION      THEORY 


15 


example,  in  the  City  of  Philadelphia,  and  some  people  casu- 
ally meet  at  a  club  around  the  street,  and  they  wonder 
whether  the  people  of  Philadelphia  really  would  like  a  tele- 
phone system.  They  are  not  certain  at  all  about  it.  They 
think  perhaps  they  would.  So  the  first  thing  they  do,  they 
get  some  canvassers  to  go  to  work  and  test  public  sentiment, 
feel  it  out  a  little,  and  perhaps  put  a  few  articles  in  the  papers, 
and  they  find  some  response,  and  they  conclude  perhaps  the 
people  in  Philadelphia  in  1914  might  hke  a  telephone  system. 
So  they  organize  a  company  and  see  how  they  can  raise 
capital.  They  get  in  touch  with  lawyers  very  early  in  the 
game,  of  course,  and  prepare  for  the  legal  papers  necessary, 
and  then  they  apply  to  the  proper  authorities  for  the  permit 
and  franchise,  and  incorporation,  of  course.  Then  they 
complete  the  raising  of  necessary  funds,  engage  a  proper 
office  building,  and  proceed  to  secure  engineers  to  provide 
plans  and  specifications,  and  they  go  out,  with  considerable 
effort  and  trouble,  to  try  and  find  out  where  to  locate  the 
cables  and  where  to  locate  the  switchboards.  They  do  not 
know  anything  about  it,  but  they  always,  by  a  curious  coinci- 
dence, finally  succeed  in  locating  just  where  the  present 
stations  are  and  switchboards,  and  they  finally  decide  on 
exactly  the  present  cables.  They  knew  nothing  about  it  to 
start  with.  They  put  their  engineers  to  work  to  determine 
just  what  the  traffic  will  require  in  each  street,  and  they 
finally  end  in  deciding  it  requires  just  what  is  there  now, 
and  they  ultimately  let  contracts  for  such  part  of  the  work 
as  they  do  not  decide  to  do  by  direct  labor  and  proceed  with 
the  supervision  of  those  contracts,  the  construction  of  the 
property  and  canvassing  for  business,  and  putting  the  plant 
into  operation  as  fast  as  possible. 

"Q.  All  that  is  very  real? 

"A.  It  is  absolutely  fanciful  and  fantastic  as  to  any  con- 
dition that  will  ever  confront  a  company  that  is  already  in 
business.  It  never  will  have  to  do  that.  It  never  has  done 
it  to  anything  like  the  extent  proposed  here.  It  is  a  species 
of  dreamland  investigation." 

PRESENT    COST    OF    ATTACHING    BUSINESS 
UNRELIABLE 

The  attempt  is  often  made  to  give  such  dreamland 
investigation  apparent  stability  by  using  actual  costs 
incurred  by  the  utility  along  the  same  lines  in  recent 
years.  Such  a  foundation  is  wholly  unreliable  for  the 
costs  necessary  in  acquiring  new  business  for  a  plant 
long  since  in  operation  can  in  no  sense  be  evidence  of 
the  cost  which  would  be  incurred  in  acquiring  new 
business  for  a  plant  with  no  patrons.  No  engineering 
or  other  estimate  can  possibly  be  made  which  could 
indicate  with  any  degree  of  exactness  the  amount  of 
money  which  would  be  necessary  to  expend  to  create 
the  business  of  a  long  established  utility  company 
upon  the  theory  that  in  the  year  1915  this  utility  was 
not  in  existence.  For  instance,  in  the  case  of  a  gas 
and  electric  company,  to  imagine  that  a  large  modern 
city  with  its  street  car  service,  its  elevators,  its  factories, 
its  myriads  of  lights,  should  suddenly  be  placed  in  a 


position  in  which  this  entire  plant  and  connections  of 
every  kind  and  description  were  blotted  out  of  existence 
is  to  imagine  the  inconceivable. 

The  allowance  to  a  company  of  a  claim  of  this  kind 
as  evolved  by  the  reproduction  method  would  result 
in  forcing  the  public  to  pay  out  yearly  large  sums  of 
money  to  cover  imaginary  expenses  which  never  have 
been,  and  never  will  be  incurred.  However  much  we 
may  admire,  from  a  theoretical  standpoint,  the  inge- 
nuity of  engineers  in  working  out  this  development  cost, 
it  must  always  be  borne  uppermost  in  mind  that  the 
end  sought  is  to  impose  yearly  charges  of  real  money 
based  on  imaginary  suppositions.  As  was  said  in  the 
brief  of  the  City  of  Milwaukee  filed  in  the  case  of  City 
of  Milwaukee,  Inter venor  vs.  Wisconsin  Telephone  Com- 
pany, now  pending  before  the  Railroad  Commission  of 
Wisconsin: — 

"How  much  solicitation  on  the  part  of  the  hypothetical 
telephone  company  would  be  necessary  to  induce  the  First 
National  Bank  of  the  City  of  Milwaukee  that  a  telephone 
was  necessary  for  them,  and  that  they  ought  to  install  a 
telephone.''  The  mere  statement  of  this  proposition  show* 
the  utter  ridiculousness  of  this  item.  The  chances  are  if 
there  were  no  telephones  in  the  City  of  Milwaukee,  and  a 
new  plant  were  to  be  put  in,  the  City  of  Milwaukee  would 
be  obliged  to  hire  a  police  force  to  keep  the  crowd  away  from 
the  telephone  office,  as  there  would  be  so  many  people  asking 
for  telephone  service"  (page  45). 

Whatever  sums  of  money  have  been  actually  spent 
by  the  public  utility  in  the  past  for  the  purpose  of 
obtaining  the  present  business  have,  in  most  cases 
been  long  since  paid  for  by  the  utility  out  of  rates 
collected  from  the  public.  The  public  having  paid 
these  costs  once  should  not  be  called  upon  to  pay  them 
a  second  time.  While  it  would  be  strange,  indeed,  if 
a  public  service  commission  should  require  that  the 
public  should  again  repay  the  costs  of  attaching  busi- 
ness which  have  actually  been  incurred,  yet  it  certainly 
would  be  the  height  of  unfairness  to  permit  a  utility  to 
exact  from  the  public  a  continuing  yearly  payment  to 
cover  a  hypothetical  sum  of  money  which  it  is  estimated 
that  a  hypothetical  company  would  have  to  expend  to 
attach  its  present  business  were  that  utility  blotted  out 
of  existence. 

GOING  CONCERN  VALUE  IN  A  RATE  CASE 

Fortunately  for  the  purposes  of  a  rate  case,  this 
question  of  hypothetical  intangibles  in  so  far  as  it  is 
bound  up  in  so-called  going  concern  value  has  been 
resolved  in  favor  of  the  public  by  the  Supreme  Court 
of  the  United  States  in  the  very  recent  case  of  the  Des 
Moines  Gas  Company  vs.  City  of  Des  Moines,  decided 
June  14,  1915.  Up  to  this  time  there  was  a  reasonable 
doubt  as  to  whether  a  separate  and  distinct  allowance 


16 


THE      UTILITIES      MAGAZINE 


for  going  value  should  be  made.  In  1912,  Dr.  Robert 
H.  Whitten  in  the  first  volume  of  his  "Valuation  of 
Public  Service  Corporations"  took  the  view  that  the 
preponderance  of  precedent  was  undoubtedly  against 
the  inclusion  of  going  concern  value  in  a  valuation  for 
rate  purposes.  In  speaking  of  the  case  of  the  Cedar 
Rapids  Gas  Light  Company  vs.  City  of  Cedar  Rapids, 
223  U.  S.  665,  Dr.  Whitten  said:— 

"Taken  in  its  context,  this  seems  to  mean  that  if  a  plant 
is  in  successful  operation  it  is  entitled  to  a  valuation  based 
on  the  cost  or  the  cost  of  reproduction  less  existing  depre- 
ciation of  the  complete  plant  and  not  upon  the  mere  salvage 
value  of  its  separate  units.  If  the  plant  were  to  be  dismantled 
the  separate  units  would  have  a  comparatively  small  value, 
but  so  long  as  the  plant  is  in  successful  operation  and  entitled 
to  continue  such  operation  the  plant  must  be  valued  as  a 
going  concern.  This  seems  to  be  a  complete  denial  of  the 
claims  of  the  advocates  of  a  separate  and  distinct  allowance 
for  going  value  or  going  concern  value. 

"This  is  the  view  taken  by  Judge  Robert  Sloan,  special 
master  in  chancery,  in  his  report,  filed  April  4,  1912,  in  the 
Des  Moines  Gas  Case.  {Des  Moines  Gas  Company  vs.  City 
of  Des  Moines,  United  States  Circuit  Court,  Southern  Dis- 
trict of  Iowa,  Central  Division,  Report  of  Robert  R.  Sloan, 
Special  Master  in  Chancery,  April  4,  1912.)  Judge  Sloan 
had  been  inclined  to  allow  the  claim  of  the  company  to  $300,- 
000  as  going  value.  But  when  the  decision  of  the  Supreme 
Court  of  the  United  States  in  the  Cedar  Rapids  case  was 
handed  down  he  concluded  to  exclude  this  item.  Referring 
to  the  Cedar  Rapids  decision  he  says: — 

"  Tn  my  judgment,  after  considering  the  able  and  thorough 
arguments  of  counsel,  it  is  decisive  of  the  question,  and  holds, 
that  going  value  should  not  be  considered  in  determining  the 
basis  upon  which  the  complainant  is  entitled  to  have  its 
return  reckoned,  and  I  feel  it  is  my  duty  to  so  state.' " 

The  correctness  of  this  viewpoint  was  emphatically 
sustained  by  the  decision  of  the  Supreme  Court  in  the 
Des  Moines  case  above  alluded  to.  In  this  case  the 
contention  of  the  respective  parties  in  relation  to  going 
value  was  clear-cut  in  the  extreme.  The  city  of  Des 
Moines  contended  that  when  the  overhead  percentages 
had  been  added  to  the  base  cost  of  the  physical  property 
(the  overheads  in  this  case  being  15  per  cent)  that  the 
total  figure  thus  arrived  at  took  into  consideration  the 
fact  that  the  plant  was  in  successful  operation.  It  was 
the  contention  of  the  Des  Moines  Gas  Company  that 
with  the  overheads  added,  the  resultant  figure  merely 
represented  the  bare  bones  of  the  property,  and  that 
the  $300,000  which  the  master  had  actually  found  to 
be  the  going  value  of  the  property  must  be  allowed  in 
addition.  The  Supreme  Court,  after  stating  that  none 
of  this  $300,000  actually  found  to  be  the  going  concern 
value  existed  in  the  valuation  appealed  from,  held  that 
all  of  this  going  concern  value  was  properly  omitted, 
and  it  further  stated: — 


"When,  as  here,  a  long  estabhshed  and  successful  plant  of 
this  character  is  valued  for  rate  making  purposes,  and  the 
value  of  the  property  fixed  as  the  master  certifies  upon  the 
basis  of  a  plant  in  successful  operation,  and  overhead  charges 
have  been  allowed  for  the  items  and  in  the  sums  already 
stated,  it  cannot  be  said,  in  view  of  the  facts  in  this  case, 
that  the  element  of  going  value  has  not  been  given  the  con- 
sideration it  deserves,  and  the  appellant's  contention  in  this 
behalf  is  not  sustained." 

On  account  of  the  fact  that  this  case  was  most  ably 
argued  before  the  Supreme  Court,  and  that  the  several 
briefs  filed  by  the  Gas  Company  quoted  at  length  the 
numerous  cases  throughout  the  country  which  are 
authorities  for  the  contention  that  a  separate  and  dis- 
tinct sum  must  be  allowed  for  going  value,  the  impor- 
tance of  the  case  will  be  appreciated.  Indeed,  a  reading 
of  the  various  briefs  filed  in  the  case  shows  conclusively 
that  the  Supreme  Court  waived  aside  all  the  decisions 
which  treat  going  value  as  a  separate  element,  and 
based  its  determination  upon  the  sound  common  sense 
proposition  that  an  estimate  of  the  physical  property 
of  a  public  utility,  including  reasonable  overheads, 
arrived  at  by  the  reproduction  method  results,  per  se, 
in  giving  to  the  plant  all  the  fair  and  proper  value  to 
which  it  is  entitled. 

REPRODUCTION  METHOD  MERELY  AN  AID 

Having  pointed  out  some  of  the  criticisms  which 
inevitably  will  be  apparent  to  anyone  who  tempers  his 
admiration  of  the  ingenious  theory  of  reproduction  cost 
with  rational  common  sense,  the  question  naturally 
arises,  has  reproduction  value  any  relation  to  fair  value, 
and  if  so,  what?  The  Supreme  Court  of  the  United 
States  completely  and  authoritatively  answered  that 
question  in  the  Minnesota  Rate  Case  when  it  said 
"The  cost-of -reproduction  method  is  of  service  in  as- 
certaining the  present  value  of  the  plant,  when  it  is 
reasonably  applied  and  when  the  cost  of  reproducing 
the  property  may  be  ascertained  with  a  proper  degree 
of  certainty.  But  it  does  not  justify  the  acceptance  of 
results  which  depend  upon  mere  conjecture."  Such  a 
statement  as  this  expresses  what  I  believe  to  be  the  true 
value  of  the  reproduction  cost  method  as  applied  to 
the  valuation  of  public  utilities.  In  other  words,  the 
reproduction  method  is  of  service  when  reasonably 
applied  in  the  valuation  of  most  kinds  of  physical  prop- 
erty, but  it  is  of  no  real  service  in  estimating  the  value 
of  other  classes  of  property  such  as  rights  of  way, 
developed  business,  etc.,  for  the  values  arrived  at  by 
its  use  are  based  upo'n  mere  conjecture.  As  was  said 
by  Mr.  Justice  Hughes  in  the  Minnesota  Rate  Case 
"The  assumption  of  its  (a  railroad's)  non-existence, 
and  at  the  same  time  that  the  values  that  rest  upon 


THE      REPRODUCTION      THEORY 


17 


it  remained  unchanged,  is  impossible  and  cannot  be 
entertained." 

METHOD  MUST   BE   REASONABLY  APPLIED 

The  reproduction  method  itself  does  not  result  in 
obtaining  a  figure  which  represents  fair  value,  but,  as 
the  Supreme  Court  says,  it  is  of  service  in  ascertaining 
the  present  value,  when  it  is  reasonably  applied.  How 
reasonably  it  may  be  applied  in  any  given  case  must 
necessarily  depend  on  the  ability,  carefulness  and  fair- 
ness of  the  engineers  who  are  employed  to  make  the 
estimates.  This  in  itself  is  a  highly  important  factor 
which  always  should  be  kept  in  mind.  Reproduction 
cost,  at  best,  is  only  an  estimate.  Anyone  who  has  had 
experience  in  obtaining  bids  on  construction  even  as 
small  as  a  dwelling  house  w^'ll  be  aware  of  the  large 
differences  in  the  estimates  of  various  firms  seeking  to 
obtain  the  contract.  It  is,  therefore,  equally  and  nec- 
essarily true  that  the  estimates  of  different  engineers, 
even  when  candidly  made,  must  be  wide  apart  on  an 
estimate  so  complex  as  that  of  reproducing  the  entire 
property  of  a  public  utility.  In  actual  practice,  the 
public  utility  would  award  a  contract  to  build  to  the 
reputable  contractor  whose  estimate  was  the  lowest. 
In  a  valuation  case,  however,  the  public  utility  will  be 
found  strenuously  maintaining  the  accuracy  of  the 
highest  estimate  of  reproduction  cost  which  reputable 
engmeers  place  upon  the  property.  I  do  not  say  this 
in  criticism  of  the  position  of  the  companies  which  I 
think  are,  under  present  conditions,  in  duty  bound  to 
contend  for  liberal  estimates  of  value,  but  merely  to 
point  out  the  fact  that  engineering  estimates  based  on 
the  cost  of  reproduction  are  generally  open  to  very 
wide  modifications  even  in  as  far  as  the  physical  prop- 
erty is  concerned.  These  modifications  are  seldom 
brought  to  light,  due  to  the  fact  that  as  the  estimate 
does  not  result  in  any  actual  work,  no  independent  con- 
tractors will  consider  submitting  bids  upon  a  hypo- 
thetical plant  to  be  constructed  in  a  hypothetical 
period  of  time. 


FAIR  VALUE  NOT  A  MATTER  OF  ARITHMETIC 

But  having  pointed  out  some  of  the  numerous  short- 
comings of  the  reproduction  method,  and  having  en- 
deavored to  show  that  it  does  not  furnish  any  criterion 
either  of  exchange  value,  or  of  fair  value,  someone  will 
undoubtedly  ask  the  question,  what  can  be  offered  in 
its  place?  That  is  a  question  which  is  regularly  hurled 
at  the  heads  of  those  who  criticize  the  pet  child  of 
pubhc  utility  engineers.  The  question,  however,  while 
proper,  is  perfectly  harmless,  because  those  who  point 
out  the  shortcomings  of  reproduction  cost  have  behind 
them  the  firm  and  often  announced  judgment  of  the 
Supreme  Court  of  the  United  States.  However  much 
we  may  all  regret  that  there  is  no  easy  road  for  valuing 
the  property  of  a  public  utility  company,  however  much 
we  may  regret  that  there  is  no  simple  arithmetical 
theory  by  which  it  can  be  evolved,  yet  one  thing  is 
certain  and  that  is  that  to  obtain  the  fair  value  of  the 
property  of  a  public  utility  company  at  the  present 
time  of  the  world's  history  it  is  necessary  to  take  every 
relevant  fact  into  consideration,  and  reproduction 
value  is  only  one  and  by  no  means  the  most  important 
of  the  many  relevant  facts. 

As  was  so  well  said  by  Mr.  Justice  Hughes,  again 
quoting  from  Minnesota  Rate  Case,  "The  ascertain- 
ment of  that  value  is  not  controlled  by  artificial  rules, 
it  is  not  a  matter  of  formulas,  but  there  must  be  a 
reasonable  judgment  having  its  base  in  a  proper  con- 
sideration of  all  relevant  facts."  The  thing  that  must 
be  determined  by  the  commission  or  court  is  not  the 
original  cost  of  the  construction  of  the  property,  not 
this  plus  the  amount  of  permanent  additions,  not  the 
amount  of  market  value  of  the  stock  and  bonds,  if 
any,  not  what  would  be  the  present  cost  of  the  con- 
struction of  the  property,  not  its  earning  capacity 
under  the  present  rates,  not  the  various  other  values 
proper  for  consideration,  but  something  to  be  evolved 
and  worked  out  in  the  minds  of  the  commission  or 
court  from  all  of  these  elements,  which  something  they 
are  willing  to  say  and  will  say  is  the  fair  value  of  the 
property  in  use  for  the  convenience  of  the  public. 


RELATION  OF  REPRODUCTION  COST  TO  FAIR  VALUE 

By  MoRKis  Knowles,  C.  E. 

Director,  Course  in  Valuation  of  Public  Utilities,  University  of  Pittsburgh;  Consulting  Engineer,  Pittsburgh 


The  trouble  with  most  criticisms  and  discussion  of- 
duction  cost  is  that  they  adopt  subjects  of  consideration 
such  as  the  titles  of  the  papers  we  have  just  listened  to,  viz. : — 
"Reproduction  Value  vs.  Fair  Value,"  and  "Criticism  of  the 
Reproduction  Theory  of  Valuation."  Such  subjects  neces- 
sarily lead  to  confusion,  and  obscure  the  important  distinc- 


tion^ between  the  estimation  of  reproduction  cost  and  the 
relation  of  reproduction  cost  to  fair  value,  which  is  itself 
worthy  of  thorough  and  thoughtful  discussion. 

If  this  distinction  could  be  maintained  the  discussion 
might  be  conducted  on  a  much  more  intelligent  basis. 
Criticism  which  is  now  destructive  might  then  be  made 


18 


THE      UTILITIES      MAGAZINE 


constructive.  Fluctuations  in  prices  of  labor  and  material 
would  not  be  advanced  as  an  argument  against  computing 
reproduction  cost,  but  helpful  suggestions  might  result  from 
a  consideration  of  the  most  reasonable  method  of  allowing 
for  these  fluctuations  in  such  estimates.  It  would  then 
be  readily  agreed  by  all  that  the  cost  of  removing  and 
replacing  pavement  is  a  necessary  part  of  the  cost  of  repro- 
ducing an  existing  property  and  must  be  included  in  any 
intelligent  estimate  of  reproduction  cost.  Objection  to 
inclusion  in  fair  value  might  then  be  confined  where  it 
belongs,  to  a  consideration  of  the  relation  of  cost  of  reproduc- 
tion to  the  amount  allowed  for  rate  making  purposes. 

From  this  point  of  view  cost  of  reproduction, — i.e., 
replacement  of  existing  property, — is  a  logical  determination, 
the  estimation  of  which  is  generally  agreed  upon  as  important 
as  an  element  for  consideration  in  all  valuation  and  rate 
making  studies.  In  order  that  they  shall  be  helpful  such 
estimates  must  be  made  by  experienced  engineers  and 
appraisers,  honest  in  thought  as  well  as  in  the  purpose  of 
establishing  a  fair  estimate  of  what  it  would  cost  in  outlay 
of  money  to  reproduce  the  plant,  business  and  whole  property 
of  the  utility  in  question  at  the  time  of  the  investigation. 

Notwithstanding  the  suggestion  of  the  second  author,  the 
speaker  fails  to  see  the  bearing  on  the  subject,  provided  the 
distinction  above  referred  to  is  maintained,  of  the  estimated 
cost  of  reproduction  of  an  entirely  different  plant  designed 
to  give  equal  service  and  based  upon  relatively  unerring 
hindsight  rather  than  imperfect  human  foresight.  If  cost  of 
reproduction  is  to  mean  anything  at  all,  it  must  mean  the 
estimated  cost  of  reconstructing  the  identical  projjerty, 
under  the  conditions  as  they  exist  at  the  time  of  the  investi- 
gation, and  with  unit  prices  of  material  and  labor  as  of 
about  the  same  time;  making  of  course  proper  allowance, 
by  some  reasonable  method  of  weighted  averages,  for  the 
fluctuations  incident  to  market  changes,  so  that  a  normal 
rather  than  extremes  will  be  used.  If  pipes  are  laid  under 
paving,  then  by  all  means  include  the  cost  of  taking  up  and 
replacing  the  same,  and  if  land  has  increased  or  decreased 
in  value,  then  estimate  what  it  would  cost  to  acquire  it  at 
the  present  time;  leaving  for  later  consideration  the  bearing 
of  this  cost  of  reproduction,  estimated  in  this  way,  upon 
the  final  determination  of  the  fair  amount  for  whatever 
purpose  is  in  view. 

NON-PHYSICAL  ELEMENTS 

In  the  same  way  the  non-physical  or  so-called  "  intangible  " 
costs  should  be  estimated,  as  of  the  present  time,  on  the 
basis  of  mature  judgment  founded  on  the  actual  experience  of 
companies  during  their  days  of  organization,  construction 
and  development.  Such  calculations  are,  of  course,  no 
more  than  estimates,  just  as  are  the  computations  of  cost 
of  reproduction  of  the  physical  items,  but  they  are  not 
"mere  guesses"  any  more  than  any  estimate,  founded  on 
well  informed  judgment,  is  a  guess. 

The  speaker  recognizes  the  difficulty  in  estimating  the 
cost  of  reproducing  the  business  of  a  successful  going  concern, 
and  he  agrees  as  to  the  uniqueness  of  the  conception  of  a 


utility  suddenly  wiped  out  while  assuming  all  other  conditions 
to  remain  exactly  the  same  as  they  are  in  the  presence  of  the 
utility.  Nevertheless  his  common  sense,  based  upon  practi- 
cal experience,  tells  him  that  it  would  cost  more  to  reproduce 
a  successful  going  business  than  it  would  cost  to  reproduce  its 
"bare-bones,"  the  physical  units — and  he  is  convinced  that 
an  estimate  of  the  probable  deficit  below  a  fair  return,  which 
would  be  experienced  by  a  plant  if  its  physical  elements 
were  reproduced  at  the  present  time  and  if  it  were  operated 
until  it  acquired  the  business  of  an  existing  successful  plant, 
is  the  best  method  of  measuring  this  element  of  reproduction 
cost  and  entirely  consistent  with  the  logical  replacement 
conception.  It  is  evident  from  his  criticism  of  this  con- 
ception as  "fantastic  in  the  extreme"  that  Mr.  French  has 
no  understanding  of  this  important  and  inevitable  feature 
of  the  early  history  of  all  public  utilities.  Criticism  on  this 
point  would  be  more  helpful  if  it  would  suggest  improvement 
in  the  method  of  making  the  estimate,  rather  than  to  confuse 
the  issue  by  mixing  it  up  with  a  consideration  of  the  entirely 
different  questions  coming  under  the  head  of  the  relation  of 
cost  of  reproduction  to  fair  value. 

This  failure  to  maintain  important  distinctions  is  again 
emphasized  by  Mr.  French's  argument  that  "whatever  sums 
of  money  have  been  actually  spent  in  the  past  for  the  purpose 
of  obtaining  the  present  business,  have  in  most  cases  been 
long  since  paid  for  by  the  utility  out  of  rates  collected  from 
the  public."  Such  sums  of  money  belong  among  the  ele- 
ments of  the  historical  cost,  and  this  statement,  even  if 
correct  has  nothing  to  do  with  a  discussion  of  the  cost  of 
reproducing  now  the  business  of  a  utility. 

Nor  is  the  citation  of  the  Des  Moines  Gas  case  particularly 
convincing  proof  that  the  Supreme  Court  does  not  recognize 
"going  cost"  as  an  element  in  estimating  the  reproduction 
cost  of  the  property  and  business  of  a  utiUty.  In  the  first 
place,  the  Supreme  Court,  in  common  with  others  who 
have  discussed  the  subject,  has  not  always  clearly  distin- 
guished between  the  estimation  of  cost  of  reproduction  and 
the  determination  of  fair-value.  And  secondly,  the  very 
quotation  which  Mr.  French  uses  states  clearly  that  the 
Supreme  Court  was  not  deciding  the  issue  in  question,  but 
only  that, 

"It  cannot  be  said,  in  view  of  the  facts  in  this  case,  that 
the  element  of  going  value  has  not  been  given  the  considera- 
tion it  deserves." 

Mr.  French's  interpretation  is  an  unwarranted  extension 
of  the  clear  meaning  of  the  decision,  and,  in  fact,  in  this 
same  decision,  the  Supreme  Court  said : 

"That  there  is  an  element  of  value  in  an  assembled  and 
established  plant,  doing  business  and  earning  money,  over 
one  not  thus  advanced,  is  self-evident.  This  element  of 
value  is  a  property  right,  and  should  be  considered  in  deter- 
mining the  value  of  the  property,  upon  which  the  owner 
has  a  right  to  make  a  fair  return,  when  the  same  is  privately 
owned,  although  dedicated  to  public  use.  Each  case  must 
be  controlled  by  its  own  circumstances,  and  the  actual 
question  here  is :  In  view  of  the  facts  found,  and  the  method 
of  valuation  used  by  him,  did  the  master  sufficiently  include 
this  element  in  determining  the  value  of  the  property  of 
this  company  for  rate  making  purposes? " 


THE      REPRODUCTION      THEORY 


19 


ORIGIN  OF  USE  OF  REPRODUCTION 

Estimates  of  cost  of  reproduction  are,  of  course,  useful 
only  when  they  are  carefully  and  honestly  made.  The 
speaker  joins  in  the  condemnation  of  the  engineer  who,  in 
order  to  serve  the  interest  of  his  client,  places  his  estimate 
of  cost  of  reproduction  above  the  sum  for  which  he  honestly 
beUeves  the  whole  property  could  be  fairly  reproduced. 
But  he  believes  that  such  instances  are  much  more  rare 
than  is  often  intimated  and  he  objects  strongly  to  the  sug- 
gestion that  reproduction  cost  and  the  current  methods  of 
estimating  it  were  invented  by  engineers  for  the  purpose  of 
maintaining  high  rates  of  utility  companies.  This  is  cer- 
tainly quite  as  far  from  the  truth  as  would  be  the  statement 
that  original  cost  was  invented  by  municipal  officials  for 
the  purpose  of  depriving  utilities  of  a  portion  of  their  property. 

The  origin  of  the  estimation  of  cost  of  reproduction  is 
perhaps  clouded  in  obscurity,  but  the  frequency  of  situations 
in  which  there  is  a  total  lack  of  evidence  of  any  other  kind 
to  be  used  as  a  basis  of  estimating  the  fair  amount, — i.e., 
of  books  and  other  records — suggests  the  much  more  probable 
explanation  that  the  use  of  this  line  of  information  was  born 
of  necessity,  rather  than  the  fanciful  one  that  it  was  originally 
invented  for  the  purpose  of  imposing  inequitable  burdens 
upon  a  long-suffering  public.  In  spite  of  his  imaginative 
picture  of  the  mental  processes  of  the  old  bandit  who  first 
applied  the  process  to  the  gas  business,  Mr.  Eshleman  would 
seem  to  share  this  view  to  a  certain  extent  when  he  says: — 

"The  inventories  and  the  reproduction  information  are 
very  valuable  because  unfortunately  it  is  always  very 
difficult  to  determine  the  actual  investment  and  determine 
the  amount  on  which  an  earning  ought  to  be  permitted 
because  the  original  evidence  is  so  often  lost." 

Just  as  it  is  absurd  to  accuse  the  engineer  of  originating  cost 
of  reproduction  from  improper  motives,  it  is  equally  im- 
proper to  blame  him  for  the  general  agreement  upon  its 
usefulness  as  a  line  of  evidence  in  investigations  of  this 
sort.  The  Supreme  Court  decisions,  which  the  critics  of 
the  method  have  quoted,  together  with  the  wording  of  our 
Pennsylvania  Public  Service  Law  and  of  similar  acts,  indicate 
clearly  that  the  blame  for  this,  if  any,  is  with  the  courts 
and  legislatures  and  not  with  the  engineer,  who  has  been 
called  upon  by  the  courts  to  apply  his  special  training  and 
experience  to  the  presentation  of  this  useful  kind  of  informa- 
tion. In  estimating  the  cost  of  reproduction  the  engineer  is 
concerned  only  in  expressing  his  opinion  as  to  the  money 
that  will  be  required  to  reproduce  the  property  in  question 
and  if  he  is  honest  he  will  follow  this  through  to  the  logical 
end  without  allowing  his  opinion  to  be  affected  by  whatever 
views  he  may  hold  upon  the  entirely  different  question  of 
the  relation  of  such  cost  of  reproduction  to  fair  value. 

Nevertheless,  the  speaker  does  not  agree  with  Mr.  Eshle- 
man that  the  engineer  should  be  restrained  from  forming 
and  expressing  an  opinion  as  to  the  proper  amount  upon 
which  the  utility  should  be  permitted  to  earn.  He  agrees 
as  to  the  importance  of  distinguishing  clearly  between  the 
engineer's  expression  of  such  opinion,  and  his  testimony 
as  to  the  estimate  of  cost  of  reproduction.  But  that  such 
expression  of  opinion  is  not  an  unwarranted  usurpation  of 


the  function  of  the  governmental  tribunal  and  is  not  so 
considered  by  such  bodies  is  proven  to  the  speaker  by 
numerous  experiences  in  Pennsylvania,  where  the  courts 
and  the  Commission  have  expressed  their  willingness  to 
hear  such  testimony,  and  to  give  it  such  deserved  weight 
as  their  opinions  of  the  breadth  of  view  and  soundness  of 
judgment  of  the  witness  justified. 

RELATION  OF  REPRODUCTION  COST  TO  FAIR 

VALUE 

This  latter  phase  of  the  question,  to  which  we  may  now 
direct  our  attention,  may  be  considered  from  two  different 
points  of  view,  viz.,  that  of  law  and  that  of  equity.  From 
the  point  of  v  iew  of  existing  law,  the  speaker  believes  that  a 
perusal  of  court  decisions  can  lead  to  no  other  conclusion 
than  that  the  cost  of  reproduction  is  a  most  important  item 
of  evidence  in  determining  fair  value  and  that  upon 
it,  with  occasional  modifications  most  of  the  decisions 
have  actually  been  based.  The  consideration  given  to  other 
evidences  of  value  such  as  are  referred  to  by  Mr.  French 
at  the  close  of  his  paper  (original  cost,  market  value  of 
stocks  and  bonds,  earning  capacity  under  present  rates, 
etc.),  has  been  theoretical  rather  than  actual. 

Dozens  of  cases  might  readily  be  cited  to  support  this  view, 
but  as  the  Des  Moines  Gas  Case  '  has  been  mentioned  as 
the  most  recent  expression  by  the  Supreme  Court,  this  one 
example  will  suffice.  Here  the  court  quotes  the  master, 
with  tacit  approval  as  arriving  at  the  "present  value  of 
physical  property"  by  estimating  "what  it  would  cost  to 
produce  it  at  the  present  time  new,"  and  then  adding  "over- 
heads" and  deducting  depreciation.  Again,  apparently  with 
the  full  approval  of  the  court,  the  master  is  quoted,  in  his 
discussion  of  "overheads,"  as  follows: — 

"It  is  not  a  question  of  what  was  actually  expended 
therefor  in  the  plant  in  question,  but  what  would  it  cost  to 
reproduce  a  similar  plant  at  the  present  time.  It  is  through 
this  method  we  reach  the  present  value  of  this  plant  new, 
and  then  when  it  is  properly  depreciated,  according  to  the 
condition,  life  and  age  of  its  various  parts,  we  reach  the 
present  value  of  the  plant  in  its  present  condition.  It  is 
not  a  perfect  method,  but  it  is  the  best  method  therefor, 
and  results  as  nearly  as  possible  in  giving  the  present  value 
of  the  plant.  No  other  method  known  has  proved  so 
satisfactory." 

Such  a  conference  as  this,  however,  need  not  spend  so 
much  time  in  discussing  the  question  from  the  point  of  view 
of  law  as  from  that  of  equity.  It  may  well  interest  itself, 
not  so  much  in  what  the  law  is,  as  in  what  the  law  ought  to 
be.  The  speaker  has  the  greatest  respect  for  the  courts  and 
their  decisions,  but  believes  we  should  express  our  differences 
with  them  when  we  believe  they  have  reached  wrong  results 
by  incorrect  methods  of  reasoning.  And  as  he  is  convinced 
that  the  truth  must  in  the  end  prevail,  he  has  every  confidence 
that  if  the  law  as  it  now  stands  is  wrong,  every  court  in  the 
land  from  the  lowest  up  to  the  Supreme  Court  of  the  United 
States,  will  eventually  reverse  itself  on  this  question  of  the 
relation  of  the  cost  of  reproduction  to  fair  value  for  rate 
making  purposes. 

^  Des  Moines  Gas  Company  vs.  City  of  Des  Moines,  238  U.  S.  113. 


20 


THE      UTILITIES      MAGAZINE 


Approaching  the  question  from  the  point  of  view  of  equity, 
the  speaker  finds  himself  to  a  considerable  extent  in  agree- 
ment with  the  position  so  well  expressed  by  the  paper  of 
the  Honorable  John  M.  Eshleman.  He  agrees  that  it  is  un- 
fortunate that  the  word  "value"  should  have  crept  into 
these  discussions  and  that  a  far  different  result  would  have 
been  reached  if  the  courts  had  set  out  to  determine  the  fair 
amount  upon  which  a  reasonable  return  should  be  paid 
rather  than  the  "fair  value,"  with  all  the  confusion  attaching 
to  the  name.  He  believes  that  there  is  a  sense  of  compen- 
sation, of  reciprocity,  in  the  word  "return"  and  that,  in 
equity,  when  we  speak  of  a  fair  return,  we  mean  not  a 
reasonable  income  upon  some  kind  of  valuation,  but  a 
giving  back  to  the  investor  a  complete  and  fair  equivalent 
for  what  he  has  devoted  to  the  public  service.  Consequently, 
he  believes  that  the  amount  upon  which  a  utility  is  entitled 
to  earn  a  fair  return  is  the  actual  legitimate  total  invest- 
ment in  the  property  as  determined  by  the  total  expenditures, 
not  only  in  dollars  and  cents,  but  in  time,  energy,  ingenuity 
and  effort. 

HISTORICAL  OR  ORIGINAL  COST 

In  speaking  of  total,  actual  or  historical  cost,  the  speaker 
desires  to  emphasize  the  distinction  between  this  and  book 
cost,  or  any  incomplete  estimate  of  historical  cost.  He 
believes  that  actual  cost  was  well  defined  by  the  Wisconsin 
Railroad  Commission  when,  in  Payne  et  al  vs.  Wisconsin 
Telephone  Company  4  W.  R.  C.  R.  51,  it  said, 

"Every  effort  honestly  put  forth,  every  dollar  properly 
expended,  every  obligation  legitimately  incurred  in  the 
establishment  of  an  efficient  public  utility  business  must 
be  taken  into  consideration  in  the  making  of  rates  for  such 
business." 

The  distinction  between  actual  cost  and  book  cost  will 
be  generally  recognized  by  the  critics  of  the  reproduction 
method,  when  it  requires  the  elimination  of  excessive  in- 
creases of  plant  valuation  on  the  books,  because  of  fictitious 
transactions,  stock  manipulation  and  other  operations 
characteristic  of  early  public-utility  financing.  But  it  may 
be  less  easy  for  them  to  understand  this  when  it  is  pointed 
out  that  such  entries,  while  sometimes  excessive  in  amount, 
often  refer  to  expenditures  of  time,  energy  arid  ingenuity 
for  the  cost  of  which  no  other  entry  appears  on  the  books. 
The  promoters  of  a  company  may  have  given  largely  of 
their  time  and  energy  to  its  organization  and  taken  their 
entire  compensation  in  discounted  bonds  and  bonuses  of 
stock,  which  the  careful  accountant  promptly  rules  out, 
as  of  no  use  for  his  purpose,  when  he  later  investigates  the 
books.  The  strict  methods  of  technical  accounting  do  not 
permit  him  to  go  further  and  investigate  how  much  these 
expenditures  of  time  and  energy  contributed  to  the  actual 
cost  of  the  property. 

If  the  book  or  historical  investment  is  that  upon  which 
the  company  is  to  be  entitled  to  a  fair  return,  it  must  take 
into  account  such  expenditures  as  these,  even  if  they  do  not 
appear  completely  in  the  book  records.  The  interest  during 
construction,  also,  may  not  actually  be  paid  to  the  stock- 
holders who  put  up  the  money,  but  the  interest  which  they 


forego  during  that  period  is  none  the  less  a  part  of  the  cost 
of  the  plant  because  it  was  not  paid  in  cash  and  does  not 
appear  upon  the  books  of  account.  Practically  never,  too, 
except  possibly  in  the  case  of  companies  started  within  the 
past  few  years,  has  proper  account  been  taken  of  the  deficit 
below  a  fair  return  during  early  periods  of  operation  and 
the  proper  portion  thereof,  that  should  be  charged  to  capital 
account.  For  such  reasons,  in  an  experience  of  a  number 
of  years,  covering  a  large  number  of  appraisals,  the  speaker 
has  never  known  of  a  single  case  in  which  it  Was  considered 
that  the  book  records  of  cost  were  complete,  and  represented 
the  original,  actual  and  total  cost. 

It  is  here,  in  the  opinion  of  the  speaker,  that  cost  of 
reproduction  has  its  real  application  and  importance,  namely, 
in  aiding  a  judgment  in  arriving  at  a  fair  estimate  of  the 
actual,  original  historical  investment.  Original  cost  should 
be  determined  from  records  as  far  as  possible,  and  estimated 
for  all  items  for  which  records  are  not  complete.  Even  if 
no  book  records  are  available  it  is  possible  to  make  aij 
estimate  of  historical  cost,  based  on  original  conditions  and 
cost  of  labor  and  materials  at  the  time  of  construction,  in 
so  far  as  this  information  is  available,  and  make  reasonable 
allowances  for  the  probable  cost  of  items  in  connection  with 
the  non-physical  elements.  But  the  difficulty  of  making 
a  complete  estimate  of  this  character  should  always  be 
borne  in  mind,  and  even  where  books  and  records  appear  to 
be  reasonably  complete,  the  cost  of  reproduction  new  as  of 
today  may  be  of  assistance  as  a  test  of  their  completeness 
and  a  guide  to  judgment  in  arriving  at  a  final  conclusion. 

Where  no  book  records  at  all  exist,  the  cost  of  reproduction 
will  be  extremely  helpful  and,  by  taking  into  account  and 
making  allowance  for  the  elements  of  cost  of  reproduction 
which  are  known  not  to  have  been  incurred  in  the  con- 
struction of  the  existing  plant,  and  by  making  proper  allow- 
ance for  changes  in  the  cost  of  labor  and  material  from  the 
date  of  construction  to  the  time  of  valuation,  as  weU  as  for 
elements  of  cost  which  may  have  been  omitted  because  of 
incompleteness  of  records,  it  may  well  serve  as  a  suitable 
foundation  upon  which  to  base  a  fair  estimate  of  probable 
reasonable  original  cost.  If  even  records  of  the  physical 
property  are  not  in  existence,  so  that  the  portion  below 
ground  cannot  be  accurately  determined,  it  may  even  be 
useful  to  make  an  estimate  of  the  cost  of  reproduction  of  a 
suitable  plant  for  performing  the  required  service;  making 
this  the  starting  point  of  the  study  which  has  as  its  object 
the  determination  of  the  probable  reasonable  original  invest- 
ment. But  in  all  these  cases  the  writer  insists  that  in  order 
that  cost  of  reproduction  shall  be  useful  as  a  guide  to  judg- 
ment, the  estimation  must  be  based  upon  a  complete  and 
logical  conception  of  the  reproduction  of  the  plant  at  the 
time  and  under  the  conditions  and  with  the  normal  prices 
of  labor  and  material  existing  at  the  time  of  the  investiga- 
tion. 

For  the  determination  of  original  cost  in  this  sense  the 
work  of  the  accountant  is  not  sufficient.  The  accountant 
considers  only  the  property  account  as  it  appears  on  the 
company's  books  and  eliminates  therefrom  every  item  which 
is  not  supported  by  such  complete  records  as  to  convince 


THE      REPRODUCTION      THEORY 


21 


him  conclusively  of  the  nature,  amount  and  purpose  of  the 
expenditure.  In  determining  the  true  investment,  however, 
all  items  bearing  on  the  history  of  the  plant,  as  well  as  the 
experience  of  other  companies  in  the  same  field  must  be 
taken  into  account.  And,  instead  of  taking  as  final  the 
judgment  of  the  person  who  made  the  original  book  entries 
as  to  what  should  be  put  on  the  books  and  how  it  should 
be  entered,  account  must  be  taken  of  transactions  which 
never  appeared  on  any  books,  and  book  entries  must  be 
■interpreted  so  as  to  arrive  at  actual  costs  which  may  be 
very  different  from  the  expenditures  recorded. 

LOOKING  FORWARD 

The  speaker  recognizes  that  this  principle  upon  which  he 
is  in  agreement  with  the  other  speakers  (although  he  may 
differ  with  them  as  to  its  application),  is  considered  by 
many  as  contrary  to  the  law  as  now  laid  down  by  the  Supreme 
Court  of  the  United  States,  and  he  appreciates  that  it  will 
be  attacked  as  contrary  to  the  fundamental  law  regarding 
property  rights,  the  Constitution  of  the  United  States  in  the 
Fifth  and  Fourteenth  Amendments,  and  the  constitution 
and  legislative  enactments  of  the  several  states.  But  he 
has  already  stated  his  belief  that  to  the  extent  that  the 
courts  recognize  cost  of  reproduction  as  the  sole  measure  of 
fair  value,  they  are  in  error,  and  will  eventually  correct  this 
by  a  reversal  of  position. 

He  believes,  also,  that  the  courts  will  be  able  to  pierce 
through  the  fallacy  that  the  basing  of  rates  on  actual  original 
historical  cost  is  a  taking  of  property  without  due  process 
of  law,  and  therefore  unconstitutional.  Dozens  of  decisions 
contrary  to  this  opinion  can,  of  course,  be  cited,  and  one 
such  has  already  been  quoted  by  the  speaker.  The  Con- 
solidated Gas  case  is  a  leading  expression  of  the  United 
States  Supreme  Court,  with  special  application  to  land  value, 
and  there  the  court  said  with  unmistakable  clearness : — 

"And  we  concur  with  the  Court  below  in  holding  that 
the  value  of  the  property  is  to  be  determined  as  of  the  time 
when  the  inquiry  is  made  regarding  the  rates.  If  the 
property,  which  legally  enters  into  the  consideration  of  the 
question  of  rates  has  increased  in  value  since  it  was  acquired, 
the  company  is  entitled  to  the  benefit  of  such  increase." 

As  long  as  the  property  right  of  the  private  owner  in  the 
unearned  increment  of  land  value  is  recognized,  and  until  a 
changed  public  policy  and  a  new  system  of  taxation  are 
evolved,  the  courts  will  be  slow  to  abandon  this  position. 
But  as  land  is  a  particularly  good  example  of  the  point  the 
speaker  desires  to  make,  he  will  use  it  for  illustration. 

As  pointed  out  by  Mr.  Eshleman,  however,  value  in  its 
philosophic  and  economic  significance  is  essentially  sub- 
jective and  dependent  upon  the  purpose  to  which  the  property 
is  to  be  put,  as  well  as  upon  the  needs  and  resources,  both  of 
possible  purchasers  and  of  the  owner.     Expressed  in  money  it 


is  the  capitalized  net  return  in  money  or  in  use,  which  the 
owner  may  expect  to  enjoy  through  his  ownership.  And  in- 
crease of  value  in  this  sense  results  from  change  in  character 
of  use,  or  from  increased  income  which  the  owner  may  re- 
ceive by  reason  of  his  ownership.  No  question  of  change  in 
character  of  use  enters  into  the  problem  of  the  value  of  land 
held  for  public  utility  purposes;  and  such  land  has  increased 
in  value  because  of  increased  income  only  if  it  is  first  estab- 
lished that  such  increased  income  is  equitable  and  can  be  re- 
ceived. As  soon  as  the  principle  is  recognized  that  a  public 
utility  is  entitled  to  receive  in  return  for  what  it  devotes  to 
the  public  use  only  the  fair  equivalent,  namely,  a  fair  return 
upon  the  actual  reasonable  investment,  the  right  to  receive 
income  in  excess  of  a  fair  return  upon  the  original  cost  of 
land  vanishes.  The  capitalized  value  of  such  income  over 
and  above  a  fair  return  on  the  original  cost  ceases  to  be  prop- 
erty, and  the  restriction  of  rates  to  a  fair  return  upon  actual 
investment  ceases. to  be  a  taking  of  property  without  due 
process  of  law.  In'  other  words,  to  value  land  on  the  basis 
of  capitalized  income  greater  than  a  fair  return  on  its  original 
cost  in  order  to  determine  the  income  that  may  be  earned  on 
it  is  just  as  much  reasoning  in  a  circle  as  to  value  a  public 
utility  on  the  basis  of  capitalizing  total  net  income,  when 
such  net  income  is  in  excess  of  a  fair  return  upon  the  actual 
reasonable  investment. 

Nor  is  there  any  essential  injustice  in  this  solution  of  the 
problem.  The  relation  between  the  public  and  the  public 
utility  is  of  the  nature  of  a  contract, — a  trusteeship,  if  you 
please.  The  investor  agrees  to  devote  to  the  use  of  the 
public  certain  amounts  of  his  money,  time  and  energy,  all 
of  which  may  be  reduced  to  dollars  and  cents  and  called  his 
actual  investment;  the  public  in  return  agrees  to  protect 
him  from  competition,  to  grant  him  the  use  of  certain  public 
property,  and  possibly  other  special  privileges,  and  to  pay 
him  a  certain  per  cent  of  return  on  every  dollar  of  his  invest- 
ment. If  each  side  fulfills  the  terms  of  this  agreement 
neither  can  claim  that  the  ends  of  justice  and  equity  have 
not  been  satisfied. 

RECAPITULATION 

To  summarize  the  point  of  view  in  this  discussion,  the 
speaker  believes  that  the  complete  original  cost  is  the  true 
measure  of  the  total  actual  investment  in  or  fair  value  of 
the  property  of  a  public  utility.  There  is  danger,  however, 
in  estimates  made  by  novices  and  inexperienced  appraisers 
that  a  realization  of  the  actual  experience  of  utility 
companies  may  be  lacking,  and  thus  that  sufiicient  allow- 
ances may  not  be  made  for  all  elements  and  items  of  invest- 
ments. Reproduction  cost  new,  withall  proper  allowances 
for  appreciation  and  depreciation,  is  an  excellent  guide,  and 
in  the  absence  of  history  and  when  used  with  judgment, 
may  be  used  to  form  an  estimate  of  complete  investment 
which  will  be  fair  alike  to  the  utility  and  the  public. 


22 


THE      UTILITIES      MAGAZINE 


DISCUSSION  OF  MR.  ESHLEMAN'S  PAPER  ON  "A  CRITICISM  OF  THE  REPRODUCTION 

THEORY  OF  VALUATION" 

By  Halbert  P.  Gillette 
Consulting  Engineer,  Neic   York 


There  are  two  fundamental  theories  of  public  utility  val- 
uation, the  " agency  theory "  and  the  "competitive  theory." 
Several  years  ago  I  first  coined  these  terms  and  published 
an  article  showing  that  few,  if  any,  courts,  commissions  or 
engineers  had  consciously  recognized  the  existence  of  the 
two  different  premises  upon  which  they  had  attempted  to 
base  their  valuation.  At  that  time  I  espoused  the  "  agency 
theory"  almost  without  reservation,  as  Mr.  E.shleman  now 
does.  But  since  then  I  have  come  upon  many  cases  that 
have  led  me  to  question  seriously  its  general  application. 

The  "agency  theory"  in  effect  was,  perhaps,  first  suggested 
in  a  railway  rate  case  by  Mr.  Brooks  Adams  in  the  "  Spokane 
Rate  Case"  before  the  Interstate  Commerce  Commission. 
As  I  remember,  he  argued  that  the  railways  were  and  always 
had  been  "trustees"  and  that  all  that  they  had  earned  in 
excess  of  6  per  cent  on  their  actual  investments  was  held  in 
trust  for  the  public  and  did  not  belong  to  the  stockholders. 
Commissioner  Prouty  rejected  this  contention  as  being 
legally  and  practically  untenable.  If  6  per  cent  were  a 
"fair  return,"  and  more  than  6  per  cent  had  been  earned, 
those  individuals  who  had  paid  the  excess  could  not  even 
be  found.  Should  the  excess,  therefore,  be  handed  back 
to  some  other  individuals  called  the  "public"?  Judge 
Prouty  could  see  neither  equity  nor  legality  in  such  an 
action. 

Now  let  us  reverse  the  condition,  and  take  a  railway  that 
has  earned  less  than  6  per  cent — which  probably  applies 
to  the  majority  of  railways — then  according  to  the  "agency 
theory,"  such  a  railway  could  claim  that  the  "public"  should 
make  good  the  deficit.  But  here  again,  we  must  ask  what 
"public".''  The  people  who  failed  to  pay  adequate  rates? 
Or  some  other  people?     The  problem  in  equity  is  a  poser. 

As  I  look  at  it  now,  we  have  all  been  trying  to  do  the 
impossible  in  sticking  to  a  single  theory.  Mr.  Eshleman,  as 
he  says,  proposed  nothing  new  when  he  advocates  the 
"agency  theory,"  and  there  is  nothing  new  in  the  proposal 
that  it  be  made  retroactive.  But  certainly  if  it  be  made 
rigorously  and  wholly  retroactive  it  leads  not  only  to  absurd 
results  in  many  cases  but  to  positively  unjust  and  often 
illegal  acts. 

Having  now  before  us  two  clear  cut  theories  of  appraisal, 
why  is  it  that  intelligent  and  fair-minded  men  differ  so 
radically  as  to  which  should  be  selected?  I  think  the 
answer  can  only  be  found  by  those  who  recognize  the  existence 
of  evolution  in  morals  and  in  economics.  What  is  "right" 
today  has  not  necessarily  been  always  right.  The  "agency 
theory"  of  regulation  of  railways  and  public  utilities  is  be- 
coming— has  not  yet  become — right  and  it  may  be  economic. 
Only  a  few  years  ago  it  did  not  even  exist,  save  in  what  may 
be  termed  its  protoplasmic  form.  Today,  even,  it  is  not 
fully  organized. 

Mr.  Eshleman  says:  "The  discussion  of  valuation  with 


relation  to  railroads  as  applied  to  rate  controversies  has 
until  recently  been  of  the  most  general  character." 

True,  and  as  a  corollary  thereto,  we  must  add  that  the 
discussions  have  been  gradually  evolving  the  new  theory  of 
agency  relationship.  It  sprang  from  no  head  full  grown. 
Yet  it  is  seriously  proposed  to  make  this  new  theory  retro- 
active in  valuing  railway  and  utility  property  in  all  cases. 
At  least  that  is  the  general  proposition,  but  it  remains  general 
only  until  it  leads  to  enormously  high  values.  Then  public 
commissions  are  apt  to  be  quite  agile  in  finding  exceptions 
to  the  general  rule.  Let  them  find  a  utility  that  has  suffered 
great  deficits  in  fair  return,  do  they  then  find  ways  to  recoup 
the  deficits?  Not  at  all.  They  then  throw  most  of  the 
deficits  out  on  the  ground  that  they  were  "not  reasonable," 
that  the  company  was  ill  managed,  its  plant  "overbuilt," 
or  what  not. 

It  is  a  peculiar  theory,  indeed,  that  serves  to  deprive 
a  successful  company  of  its  plant  by  giving  it  only  a  theoreti- 
cally depreciated  value  thereon,  yet  also  deprives  an  un- 
successful company  of  its  "deficits  in  fair  return."  The 
same  theory  is  made  to  serve  to  take  away  a  "  surplus"  from 
one  company  and  a  deficit  from  another. 

Mr.  Eshleman  points  out  what  seems  to  him  to  be  two 
fatal  objections  to  the  "reproduction  theory" — which  is 
the  "competitive  theory,"  at  least  in  part, — but  what  of 
the  really  fatal  objections  to  the  "agency  theory"  when 
made  retroactive? 

If  neither  theory  is  free  from  objections  when  made 
retroactive,  what  must  we  infer?  My  answer  is  that  there  is 
no  thoroughly  logical  theory  that  can  be  applied  where 
evolution  has  produced  a  condition  such  as  here  confronts 
us,  and  that  some  sort  of  compromise  must  occur.  As  a  fact 
these  railways  and  utilities  neither  have  been  full  public 
agents  nor  are  they  so  even  now  in  any  state  in  the  Union. 
In  California,  to  which  Mr.  Eshleman  specifically  refers,  the 
City  of  Los  Angeles  is  now  building  an  electric  power  system 
to  compete  with  electric  companies  and  the  Railroad  Com- 
mission has  no  power  to  stop  such  comf)etition.  Is  this 
an  application  of  the  ''agency  theory"  of  public  utility 
control? 

Mr.  Eshleman  mentions  two  private  California  water 
works  "reduced  to  junk"  by  public  competition.  Is  this 
evidence  either  of  an  agency  condition  or  of  a  "monopoly"? 
Any  one  can  cite  scores  of  just  such  instances  and  usually 
the  worst  cases  are  in  the  very  states  that  claim  to  have 
adopted  the  new  agency  theory  of  rate  control.  Surely, 
then,  the  theory  is  both  new  and  unapplied  save  in  part. 
And,  if  so,  where  is  the  "logic"  in  speaking  of  it  as  some- 
thing that  always  has  been? 

Closely  woven  in  the  general  web  of  error  is  the  claim 
that  these  utilities  and  railways  are  "  monopolies. "  If  one 
thing  has  been  made  clear  to  me  by  my  ten  years  of  appraisal 


THE      REPRODUCTION      THEORY 


23 


work  for  utility  commissions  and  companies,  it  is  this: 
No  vtility  or  railway  is  or  has  been  jree  frovi  competition, 
existent  or  potential ,  and  ustially  competition  has  served  to  keep 
rates  down  to,  or  even  below,  a  fair  return  on  the  invested  capital. 

When  I  first  began  to  reah'ze  that  the  railways  and  utilities 
were  not  the  gold  mines  they  were  popularly  believed  to  be, 
I  thought  that  I  was  finding  merely  the  exceptions  and  that 
soon  I  would  come  upon  the  real  gold  mines,  but  I  have 
learned  that  what  I  conceived  to  be  the  exceptions  were  the 
rule. 

Competition  in  the  electric  lighting  field  exists  and  always 
has  existed.  The  electric  light  companies  had  to  meet  at 
the  very  start,  and  still  meet,  the  kerosene  lamp  and  the 
gas  light.  Electricity  forced  these  slowly  but  surely  into 
the  background  but  not  out  of  existence.  And  in  the  forcing 
process,  electric  light  prices  steadily  fell.  Then  came  a 
potential  competition  that  often  became  actual.  I  refer  to 
the  building  of  competitive  electric  plants  by  other  companies 
and  by  municipalities. 

"Monopoly"  of  public  utilities  and  railways  is  also  one 
of  those  products  of  evolution  that  is  yet  in  the  process 
of  development,  having  never  really  existed  save  in  most 
incomplete  form.  Yet  Mr.  Eshleman's  argument  is  built 
upon  the  assumption  not  only  of  present  but  of  past  condi- 
tions of  monopoly.     He  says: 

"  But  in  the  realm  of  a  public  utility  we  have  a  situation 
that  is  peculiar.     We  have  here  an  agency  that  to  many 

of  its  patrons  is  always  a  monopoly Our  main 

assumption  is  that  these  agencies  are  and  of  right  ought  to 
be,  upon  considerations  of  sound  economics,  monopolies." 

That  they  are  monopolies,  save  in  part,  I  deny.  That 
they  ought  to  be  monopolies  in  the  future  may  be  sound 
economics,  provided  there  always  goes  with  this  condition 
the  full  protection  that  the  agency  relationship  implies. 
But,  I  ask,  what  railway  or  public  utility  commission  is 
striving  to  apply  to  the  fullest  this  monopoly  rule?  The 
"jitney  buses"  have  had  disastrous  effect  upon  many  street 
railways.  There  may  be  a  public  service  commission 
somewhere  that  has  been  laboring  to  eliminate  "jitney" 
competition,  but,  if  so,  I  have  not  yet  heard  of  it. 

I  mention  such  things  not  in  criticism  of  commission  but 
as  evidence  of  failures  to  apply  the  "agency  theory";  such 
facts  make  very  clear  that  we  are  still  in  an  evolutionary 
period  as  to  public  utility  regulation. 

I  agree  with  Mr.  Eshleman  that  "If  we  had  this  problem 
in  the  beginning  and  were  not  attacking  it  in  the  middle, 
we  would  have  no  difficulty  in  agreeing  with  the  holder 
of  capital  upon  this  subject."  I  also  agree  that  "for  the 
future"  the  agency  theory  in  some  form  must  apply.  But 
this  does  not  get  us  over  our  difficulties  when  we  attempt 
to  straighten  out  the  "past,"  in  order  to  start  with  a  clean 
slate.  There  is  the  rub,  and  Mr.  Eshleman's  method  fails 
to  rub  the  slate  clean.  Legally  it  fails  at  many  spots. 
Thus,  the  United  States  Supreme  Court  holds  that  land  and 
"water  rights"  must  be  valued  not  at  their  actual  cost  but 
at  their  "present  value."  Shall  we  attempt  to  interpret 
such  decisions  so  as  to  render  the  "present"  value  of  little 
or  no  value  to  the  companies.'' 


But,  it  is  said,  courts  are  not  consistent.  Granted,  and 
what  of  it?  They  are  human  and  often  possess  less  knowl- 
edge both  of  theories  and  facts  than  we  do.  Does  not  their 
very  inconsistency  bear  out  my  contention  that  nothing 
short  of  a  compromise  is  possible  where  neither  the  "agency 
theory"  nor  the  "competitive  theory  "-has  existed  in  full 
and  where  both  have  existed  in  part?  Let  us  cease  battering 
our  heads  against  the  impossible,  for  no  clean  cut  single 
theory  exists  or  can  exist  that  will  apply  in  every  case  in 
valuing  railway  or  public  utility  property  built  and  operated 
in  the  past  under  hybrid  conditions. 

Further,  is  it  fair  to  impugn  the  motives  of  the  railways 
and  utilities  who  defend  the  reproduction  theory?  Would 
it  not  be  equally  unfair  to  attack  the  motives  of  their  im- 
pugners?  Are  "  monopoly  lawyers  and  engineers  "  less  honor- 
able than  municipality  or  state  lawyers  and  engineers?  To 
me  it  seems  that  to  be  obsessed  by  either  of  the  two  theories 
of  rate  regulation  is  to  be  blind.  I  admit  that  I  have  been 
blind,  and  I  speak  in  no  carping  manner  of  others  who  still 
are  blind  or  who,  at  least,  see  as  through  a  glass  darkly. 

Mr.  Eshleman  holds  that  an  engineer  should  testify  only 
"upon  questions  of  fact"  and  that  an  engineer  "usurps  the 
function  of  the  governmental  tribunal  before  which  he 
testifies"  when  he  presumes  to  state  the  "value"  of  property 
involved.  This  is  a  matter  of  opinion,  and,  being  an  engineer, 
perhaps  I  am  a  biased  debater  on  it.  I  know,  however,  that 
I  have  never  seen  or  heard  of  an  appraisal  made  by  any 
engineer  that  was  any  the  less  based  on  "questions  of  fact" 
because  it  resulted  in  a  statement  of  the  final  fact  sought — 
the  "value"  of  the  property. 

Even  what  Mr.  Eshleman  would  denominate  a  "question 
of  fact,"  such  as  the  "depreciated  value"  of  an  engine,  is 
founded  on  some  theory  of  depreciation.  Yes,  and  the  very 
"fact"  as  to  the  "actual  cost"  of  the  engine  is  founded  on 
some  theory  or  theories  of  accounting.  Assumptions  and 
theories  are  the  very  foundation  of  every  appraisal,  both  of 
physical  and  non-physical  property.  Shall  the  only  experts 
qualified  to  pass  on  the  application  of  the  assumptions  and 
theories  be  debarred  from  expressing  opinion  thereon?  Is 
there  something  of  the  "divinity  that  hedges  kings"  in  a 
"legal  tribunal"  that  makes  the  "tribunal"  alone  competent 
to  pass  on  anything  save  alleged  "facts"?  Can  a  commis- 
sioner, for  example,  who  knows  little  of  accountancy  and 
less  of  engineering,  unguided  by  the  opinions  either  of 
accountants  or  of  engineers  as  to  theories,  pluck  from  the 
sands  of  testimony  the  pearl,  "value,"  which  no  other  eye 
can  be  relied  upon  to  see? 

It  may  be  wise  for  an  engineer""who  has  only  part  of  the 
evidence  before  him  to  refuse  to  pass~^Hgon  the  final  "fair 
value"  of  a  property,  but  surely  there  is  nstfiing  illegal  or 
presumptuous  in  his  giving  his  opinion  as  to^lair  value" 
if  he  is  in  possession  of  all  essential  facts.  Indee(V^  such 
a  case,  I  believe  a  well-qualified  engineer  to  be  as  good  a 
judge  of  utility  or  railway  "value"  as  can  be  found. 

"Mankind,  as  a  whole,"  says  Mr.  Eshleman,  "is  interested 
in  any  plan  which  tends  to  determine  rewards  in  relation 
to  effort."  This  is  a  good  phrasing  of  one  of  the  greatest 
of  economic  laws.     But,  as  I  interpret  it,  it  leads  to  quite 


24 


THE      UTILITIES      MAGAZINE 


a  different  result  than  the  one  proposed  by  most  rate  making 
commissions,  namely,  the  holding  of  a  utility  down  to  a 
definite  percentage  of  "fair  return"  on  the  "value"  of  the 
property.  To  apply  this  law  of  "reward  proportionate  to 
performance"  a  company  should  be  allowed  a  profit  on 
what  it  saves  in  plant  construction  rather  than  on  what  it 
spends.  Marconi  should  be  and  is  rewarded  for  doing 
away  with  the  necessity  of  trans-oceanic  cables.  But  Mr. 
Eshleman's  fair  return  on  the  investment  rule  would  posi- 
tively penalize  genius,  and,  in  practice,  it  does  penalize  both 
genius  and  normal  ability.  Therein,  as  I  view  it,  lies  the 
gravest  defect  of  the  present  rate  regulative  activities.  The 
regulators  have  it  that  value — true  value — henceforth  must 
go  into  oblivion.  If  it  does,  then  there  goes  to  the  same 
realm  the  law  of  reward  proportionate  to  performance.  Let 
another  Harriman  create  values,  true  values,  by  reducing 
transportation  costs,  and  the  present  theory  of  rate  regulation 
will  be  used  to  confiscate  them  as  soon  after  creation  as 
possible. 

This  is  too  vast  an  economic  subject  for  me  to  do  more 
than  mention.  But  I  mention  it  in  the  passing  to  indicate 
that  value  and  competitive  excellence  cannot  be  as  lightly 
blown  into  oblivion  as  some  would  have  it,  and  as  many, 
indeed,  are  right  now  attempting  to  blow  it  under  the  guise 
of  judicious  regidation  of  rates. 

Mr.  Eshleman  says  that  the  return  to  a  utility  company 
should  be  only  "the  cost  of  doing  the  business  plus  a  return 
on  the  capital  necessarily  invested  in  the  business,"  and  that 
this  "is  all  that  ought  to  be  accorded  for  the  future  and  it  is 
all  that  will  be  accorded  if  the  public  has  any  business  sense." 
This  theory  is  in  complete  discord  with  his  previously  quoted 
statement  that  the  reward  should  be  proportionate  to  suc- 
cessful effort. 

A  return  based  solely  on  cost  is,  as  I  conceive  it,  the  most 
blighting  theory  that  has  yet  settled  upon  this  country.  It 
is  destined  to  drive  brains  of  the  best  order  and  courage  of  the 
highest  type  into  occupations  other  than  those  of  public 
utility  nature  or  into  foreign  lands,  seeking  escape  from  a 
rule  that  penalizes  progress. 

Our  rate  regulators,  for  the  most  part,  deny  that  this  is 
what  is  happening  or  will  happen  under  their  theory  of 
"fair  return  on  the  investment."  But  the  facts  are  against 
their  beliefs.  It  is  not  the  war  alone  that  has  brought  to 
a  pause  all  hydro-electric  development  in  Mr.  Eshleman's 
state,  for  example.  The  mere  threat  of  confiscating  all 
profits  above  8  per  cent  on  the  actual  cost  of  investments 
in  power  properties  has,  I  think,  done  more  than  any  foreign 
war  could  ever  do  toward  putting  brakes  upon  these  enter- 
prises. And  it  is  so  on  every  side  and  in  every  class  of 
public  utility  and  railway. 

Since  Edison  invented  the  incandescent  lamp,  thirty  years 
ago,  its  candle-power  efficiency  has  been  increased  twelve- 
fold per  watt  of  current  used.  At  the  same  time,  the  price 
of  current  had  also  dropped  amazingly,  long  before  public 
rate  regulation  had  been  even  suggested.  By  comparison 
how  really  insignificant  have  been  the  lighting  rate  reductions 
effected  by  commissions.  Yet  the  mere  threat  of  confiscation 
of  the  profits  dqe  to  further  economic  progress  has  chilled 


the  stream  of  capital  until  it  may  now  be  said  to  be  only 
a  glacial  river,  scarcely  moving  at  all  in  many  places. 

The  value  of  a  public  utility  is  the  present  worth  of  its 
prospective  net  earnings  (or  "profits").  If,  by  regulation, 
this  value  is  to  be  henceforth  restricted  to  actual  cost,  all 
incentive  to  increase  profits  by  skillful  engineering  and 
management  forthwith  dies.  We  are,  I  fear,  now  witnessing 
the  death  throes.  And,  if  so,  we  may  soon  enter  upon  the 
era  that  has  existed  for  a  long  time  in  Europe,  where  not  a 
single  noteworthy  advance  in  any  railway  or  public  utility 
art  has  been  recorded  in  a  generation. 

Mr.  Eshleman  contends  that  there  are  "two  absolute  bars 
to  the  application  of  the  reproduction  theory  of  valuation 
of  utilities."  The  first  of  these  bars  is  the  "impossibility 
of  imagining  the  monopoly  never  to  have  existed"  yet  with 
monopoly  results  still  there.  He  quotes  Justice  Hughes  on 
this  "impossibility."  Now  the  fact  is  that  this  difficulty  is 
one  bred  of  an  entire  misconception  of  the  underlying  prin- 
ciple of  the  reproduction  theory.  The  reproduction  theory, 
when  rightly  interpreted,  implies  competition,  actual  or 
potential,  and  it  does  not  imply  a  reproduction  of  the  existing 
utUity  plant  but  of  a  substitute  or  alternative  plant. 

A  utility  company  that  owns  a  plant  may  reasonably 
claim  that  the  best  test  of  its  value  is  the  cost  of  producing 
another  plant  that  will  perform  the  same  functions.  This,  of 
course,  implies  possible  competition.  And,  if  the  utility 
company  fully  understands  the  theory,  it  may  also  claim 
that  the  cost  of  building  up  a  similar  business  imder  com- 
petition is  a  measure  of  the  maximum  value  of  its  existing 
business  to  a  prospective  purchaser  of  the  plant.  The  com- 
pany does  not  at  any  time  claim  to  be  or  to  have  been  a 
monopoly.  It  stands  ready  to  become  a  monopoly  if  the 
public  so  wills,  and  it  may  be  desirous  of  becoming  a  monop- 
oly; but  it  denies  being  or  having  been  a  monopoly,  and  it 
points  to  the  public's  legal  right  to  compete  with  it  as  evidence 
of  that  fact. 

Having  come  to  a  parting  of  the  ways,  the  utility  com- 
pany demands  a  valuation  based  on  the  cost  of  the  best 
alternative  plant  plus  a  consideration  for  the  cost  of  securing 
an  alternative  business  attached  thereto.  This  is  strictly 
on  a  competitive  basis  of  value,  and  it  asks  that  that  basis 
be  considered,  for  upon  that  basis  it  has  lived.  But,  acting 
as  a  wise  business  man  usually  does,  the  utility  company 
stands  ready  to  accept  a  value  less — often  far  less — than  the 
cost  of  building  an  alternative  plant  plus  the  cost  of  securing 
an  alternative  business.  Often  all  the  utility  asks  is  the  bare 
cost  of  reproducing  a  new  plant  without  adding  thereto  the 
cost  of  building  up  its  business.  The  public  would  be  eco- 
nomically crazy  were  it  to  reject  such  an  offer. 

Justice  Hughes'  objection  to  the  reproduction  theory  as 
applied  to  right  of  way  vanishes  the  instant  it  is  seen  that 
it  is  not  the  identical  existing  right  of  way  that  is  to  be 
conceived  as  existing  without  a  railway  thereon,  but  that  it 
is  the  cost  of  an  alternative  right  of  way  that  is  the  criterion 
of  value  of  the  existing  right  of  way.  It  is  true  that  the 
railways  have  not  hitherto  made  this  distinction  apparent, 
but,  once  it  is  made  clear,  every  logical  difficulty  vanishes. 

Mr.  Eshleman's  second  "bar"  to  the  reproduction  theory 


THE      REPRODUCTION      THEORY 


25 


is  the  "impossibility  of  thinking  monopoly  and  competition 
at  the  same  time."  But  who  is  trying  to  do  so?  Certainly 
not  the  utility  companies.  In  the  past  they  have  certainly 
"thought  competition"  but  for  the  future  they  are  prepared 
to  "think  monopoly."  They  are  at  the  threshold  of  the 
change,  and  they  ask  the  public  rate  regulators  not  to  try 
to  think  a  monopoly  in  the  past  that  has  never  existed  there, 
save  perhaps  in  relatively  minor  degree. 

I  have  said  that  I  believe  there  must  be  a  compromise 
between  the  extreme  attitudes  of  the  utilities  and  the  public. 
This  compromise,  as  I  view  it,  should  be  based  largely  upon 
the  degree  in  which  the  utilities  have  actually  been  treated  as 
full  agents  by  the  public.  In  short  we  must  look  to  the 
history  of  each  case  for  our  answer  as  to  the  degree  of  weight 
that  should  be  given  to  the  "reproduction  theory"  and  to 
the  "actual  cost  theory"  of  valuation  of  property  built 
prior  to  regulation.  I  do  not  suppose  that  this  is  exactly 
what  the  Supreme  Court  had  in  mind  when  it  rendered  the 
Smythe  vs.  Ames  decision,  but  certainly  that  decision  is 
broad  enough  to  permit  a  public  rate  regulating  body  to  take 
the  common  sense  view  of  the  matter  above  suggested. 
Even  more  certain  is  it  that  the  Supreme  Court  will  not 
countenance  the  extreme  views  taken  by  Mr.  Eshleman  any 


more  than  it  will  countenance  the  extreme  views  often  taken 
by  public  utility  companies. 

While  I  have  pointed  out  the  nature  of  the  premises  upon 
which  the  reproduction  theory  properly  rests,  I  do  no  I  go 
so  far  as  to  claim  that  it  is  always  rigorously  applicable  in 
practice.  In  the  case  of  a  small,  simple  plant  the  full  repro- 
duction theory  can  be  applied  quite  rigorously,  but  in  a 
large  complex  plant  it  can  be  applied  only  approximately. 

Finally  let  me  add  that  even  the  advocates  of  the  agency 
or  cost  theory  themselves  rarely — if  ever — stick  to  it.  Al- 
most invariably  they  deduct  estimated  accrued  depreciation 
from  the  cost  of  the  plant,  and  when  they  do  so,  they  invari- 
ably deduct  functional  depreciation  due  to  "obsolescence" 
and  economic  "inadequacy."  But  when  they  do  this  they 
are  actually  setting  up  an  alternative  up-to-date  plant  as  their 
criterion  of  the  value  of  the  existing  plant.  They  preach 
actual  cost,  but  actually  they  practice  value;  at  least  in  part. 
To  me  this  is  one  of  the  most  interesting  logical  blunders  that 
can  be  found  in  the  whole  history  of  political  economics. 
There  is  no  such  thing  as  depreciated  cost,  but  there  is  such 
a  thing  as  depreciated  value,  and  it  is  the  latter — a  value — ^that 
these  very  advocates  of  the  cost  method  adopt. 


FALLACY  OF  THE  "REPRODUCTION  COST"  THEORY  IN  DETERMINING  THE  VALUE 

OF  PROPERTY  OF  PUBLIC  UTILITIES 

By  A.  B.  Du  Pont 

Consulting  Engineer,  Cleveland,  Ohio 


In  ascertaining  the  height  of  a  mountain,  it  is  not  necessary 
to  ascertain  either  its  bulk  or  the  nature  of  its  composition. 

Why,  then,  in  ascertaining  the  value  of  a  public  utility, 
is  it  necessary  to  ascertain  either  its  present  reproduction 
cost  or  its  original  cost? 

That  the  physical  property  of  the  utility  cost  much  or 
little  originally,  that  the  present  cost  of  reproducing  it  would 
be  much  or  little,  and  that  it  is  in  good  condition  or  bad, 
are  facts.  But  these  facts  have  no  more  bearing  on  ascer- 
taining the  value  of  the  utility  than  the  facts  that  a  mountain 
is  composed  of  gold-bearing  quartz  or  common  stone,  or  that 
there  has  or  has  not  been  erosion  of  its  surface,  have  bearing 
on  ascertaining  the  height  of  the  mountain. 

Erosion  may  have  caused  a  reduction  in  the  height  of  the 
mountain;  depreciation  may  have  caused  a  reduction  in  the 
value  of  the  utility.  But  it  is  more  foolish  to  estimate  the 
amount  that  its  physical  property  has  depreciated,  in  order 
to  ascertain  the  value  of  a  utility,  than  it  would  be  to  esti- 
mate the  amount  of  the  erosion  in  order  to  ascertain  the 
height  of  a  mountain,  for  the  reason  that  the  height  of  the 
mountain  will  have  been  decreased  in  proportion  to  the 
amount  of  erosion  at  its  summit  while  the  value  of  a  utility 
will  not  have  been  decreased  in  proportion  to  the  amount 
of  depreciation  of  its  physical  property.  In  fact,  deprecia- 
tion of  any  or  all  of  the  parts  of  its  physical  property,  result- 
ing in  lowering  of  taxes,  has  a  tendency  to  increase  the 


value  of  the  utility,  but  this  tendency  toward  an  increase 
in  value  may  be  partly  or  wholly  nullified  or  even  outbal- 
anced by  the  increased  cost  of  production  due  to  the  use 
of  the  depreciated  physical  property. 

The  utility  has  certain  physical  property  and  it  must  use 
this  particular  property  in  manufacturing  its  product,  no 
matter  what  was  its  cost  or  what  is  its  condition.  The  only 
value  which  can  attach  to  the  utility,  so  long  as  it  continues 
to  be  a  utility,  arises  from  the  sale  of  this  product. 

The  idea  of  using  either  the  reproduction  cost  or  the 
original  cost  of  the  physical  property  of  a  utility  in  determin- 
ing the  value  of  the  utility  is  so  absurd  that  the  writer  is  at  a 
loss  to  understand  why  he  or  anyone  has  ever  accepted  it. 
However,  the  fallacious  theory  is  very  generally  recognized 
today,  and,  so  long  as  utilities  are  forced,  by  government 
power,  to  accept  as  value  the  estimate  resulting  from  its 
use,  justice  is  imperiled  by  it. 

A  few  illustrations  will  serve  to  demonstrate  the  absurdity 
of  these  theories. 

HYPOTHETICAL  ILLUSTRATION  NO.   1 

Assume  two  public  utilities  located  in  the  same  or  different 
localities,  owned  by  identical  individuals,  both  in  normal 
operating  condition;  cost  and  reproduction  cost  of  physical 
property  and  earnings  identical,  but  expenses  differing  10 
per  cent. 


26 


THE      UTILITIES      MAGAZINE 


Manifestly,  the  value  of  the  utilities  would  not  be  equal. 
How,  then,  could  we  make  use  of  the  knowledge  that  cost 
and  reproduction  cost  of  the  physical  property  were  equal 
in  determining  the  value  of  the  utilities.  The  difference  in 
expenses  may  be  due  to  various  causes  beyond  control  of  the 
management,  e.g.,  in  a  street  railway,  difference  in  grades, 
difference  in  speed  at  which  it  is  practicable  to  run  cars, 
difference  in  the  length  of  the  ride  of  individuals,  or  the 
difference  in  expenses  may  be  due  to  a  difFerence  in  efficiency 
of  management. 

Whatever  the  cause  for  the  difference  in  expense,  so  long 
as  it  is  expected  that  the  difference  will  continue  to  exist, 
and  so  long  as  it  is  expected  the  earnings  will  remain  the 
same,  the  value  of  the  utilities  will  remain  unequal  although 
the  cost  or  reproduction  cost  of  their  physical  property  remains 
equal. 

HYPOTHETICAL  ILLUSTRATION  NO.  2 

Assume  the  same  utilities  with  the  same  ownership,  cost 
and  reproduction  cost  of  physical  property  and  expenses 
equal;  both  in  normal  operating  condition,  but  expected 
earnings  differing  10  per  cent. 

Manifestly  the  value  of  the  utilities  will  not  be  equal, 
whether  the  differences  in  earnings  be  due  to  natural  advan- 
tage caused  by  conditions  beyond  the  control  of  the  owners, 
such  as  better  market  for  disposal  of  product  in  proportion 
to  the  expense  or  be  due  to  the  difference  in  efficiency  of 
management  in  stimulating  earnings  without  increase  of 
expense.  No  matter  what  the  cause,  the  fact  that  the  cost 
and  reproduction  cost  of  the  physical  property  of  the  utilities 
are  equal  cannot  be  used  to  explain  the  difference  in  the 
value  of  the  utilities. 

HYPOTHETICAL  ILLUSTRATION  NO.  3 

Assume  the  same  utilities  with  the  same  ownership,  both 
in  normal  operating  condition,  with  cost  and  reproduction 
cost  of  physical  property  equal,  and  expenses  and  earnings 
equal.  In  the  judgment  of  the  owners,  however,  one  utility 
will  require  a  greater  effort  upon  their  part  than  the  other, 
to  obtain  the  like  results,  for  which  effort  they  receive  no  pay 
other  than  a  share  in  the  profits. 

Manifestly,  the  fact  that  the  cost  and  reproduction  cost  of 
the  physical  property  of  the  utilities  are  equal  will  not  help 
in  determining  the  relative  value  of  the  utilities  because  the 
value  would  be  unequal,  and  the  difference  in  value  would 
be  wholly  dependent  upon  the  difference  in  the  expected 
effort  required  from  the  owners,  in  order  to  obtain  the  same 
relation  between  the  expected  earnings  and  the  expected 
expenses. 

HYPOTHETICAL  ILLUSTRATION  NO.  4 

Assume  the  same  utilities;  same  ownership;  both  in  normal 
operating  conditions  with  exjjected  earnings  and  expenses 
equal.  Would  the  fact  that  the  original  or  reproduction 
cost  of  the  physical  property  of  one  of  the  utilities  was  10 
per  cent  greater  than  the  other,  be  an  element  that  would 
aid  anyone  in  determining  the  relative  value  of  the  utilities? 

Manifestly  not,  for  the  two  utilities  would  be  of  equal 
value  unless  their  value  was  affected  by  other  considerations. 


lying  entirely  outside  of  the  hypothesis,  such  as  a  difference 
in  the  amount  of  effort  required  from  the  owners  to  get  like 
results  from  the  use  of  the  utilities. 

There  may  be  many  reasons  for  the  difference  in  the  cost 
or  reproduction  cost  of  the  physical  property  of  the  utilities 
even  when  equal  wisdom  was  used  in  creating  the  physical 
property,  such  as  the  necessity  to  create  more  physical 
property  in  order  to  obtain  the  same  earnings,  the  greater 
obstacles  necessary  to  overcome  in  creating  the  physical 
property  of  one  utility  over  the  other,  higher  land  values, 
etc.,  in  fact,  almost  innumerable  differences  caused  by 
differences  in  the  problem  presented  to  the  owners  at  the 
time  the  utilities  were  being  created. 

When  we  add  to  these  differences  the  difference  in  costs 
caused  by  the  difference  in  foresight  of  engineers,  and  the 
difference  in  efficiency  of  individual  constructors  of  parts 
of  the  physical  property  of  each  utility,  we  enter  into  a  maze 
that  is  so  infinitely  confusing  that  it  is,  indeed,  fortunate 
that  the  amount,  which  the  utility  has  exj)ended  upon  its 
physical  property,  has  no  more  bearing  upon  the  value  of 
the  utility  than  the  price  that  an  individual  farmer  pays  for 
his  land  has  bearing  upon  the  value  of  the  wheat  he 
produces. 

The  value  of  the  utility,  so  long  as  it  is  a  utility,  is  not 
in  any  way  dependent  either  upon  the  cost  or  the  reproduction 
cost  of  its  physical  property,  nor  upon  the  price  at  which  said 
physical  property  can  be  sold  when  detached  from  its  use  as  a 
part  of  the  utihty,  but  is  solely  dependent  upon  the  capital- 
ization (at  the  rate  money  is  worth  to  the  owners  of  the 
utility)  of  the  difference  between  that  part  of  the  return  from 
the  sale  of  the  product,  which  the  owners  of  the  utility 
expect  will  be  available  to  them,  and  the  value  which  the 
owners  attach  to  their  effort  in  causing  the  utility  to  pro- 
duce and  dispose  of  its  product. 

The  value  of  any  property  is  the  price  for  which  the  title 
to  it  can  be  purchased,  and  the  facts  stated  in  the  foregoing 
paragraph  determine  the  price  at  which  the  owners  of  the 
title  to  the  utihty  will  sell  their  title  to  it. 

From  what  has  heretofore  been  written,  it  is  certain  that 
the  value  of  any  public  utility  is  wholly  dependent  upon  the 
difference  between  its  expected  earnings  and  its  expected 
expenses.  Hence,  as  public  utilities  are  in  part  created  by 
government  assent,  and  as  the  earnings  of  the  utilities  may 
be  limited  by  government  decree,  and  as  their  expenses 
may  be  modified  by  government  action,  it  necessarily  follows 
that  the  value  of  any  public  utility  is  finally  dependent 
upon  the  expected  difference  between  its  earnings  and  ex- 
penses, resulting  from  future  activities  caused  by  the  owners, 
within  limits  expected  to  be  permitted  by  government. 
Hence  it  follows  that  the  value  of  the  property  of  public 
utilities  can  be  altered  by  government  through  decreasing 
their  earnings  or  through  increasing  their  expenses  or  both. 
Mr.  Eshleman  has  properly  warned  the  owners  of 
public  utihties  not  to  attempt  to  obtain  recognition  of 
"threat  values"  or,  as  I  prefer  to  call  them,  monopolistic 
values.  I  wish  to  warn  the  public  and  the  public  officials 
that  at  least  the  non-monopolistic  value '    of  the  property 

'A  pamphlet  on  this  subject  may  be  secured  by  addressing  the  author: 
901  American  Trust  Bldg.,  Cleveland,  Ohio. 


THE      REPRODUCTION      THEORY 


27 


of  public  utilities  must  be  recognized  by  government  or 
money  can  not  be  had  for  extending  their  services  to  the 
public,  and  even  the  service  that  they  are  now  rendering 
may  necessarily  be  curtailed. 

This  problem  must  be  solved  because,  even  though 
we  drift  into  government  ownership,  government  cannot 
know  its  cost  of  rendering  public  utility  service  until  this 
problem  is  solved.  This  for  the  reason  that  it  cannot  know 
the  risk  to  which  government  money  will  be  subjected  when 
invested  in  what  is  now  public  utility  property. 

Present  methods  of  accounting  do  not  take  into  considera- 
tion the   risk  of  investment  in  either  privately   owned  or 


government  owned  public  utilities.  However,  the  account- 
ing of  privately  owned  public  utilities  does  not  mislead  their 
owners,  because  they  know  the  difference  between  book 
value  and  real  value.  But  I  am  afraid  the  accounting  of 
government  owned  utilities  is  tending  to  mislead  govern- 
ment officials  and  the  public  and  will  continue  to  do  so 
until  there  is  charged  to  the  cost  of  service,  interest  on  the 
money  invested  in  the  property  at  the  rate  which  would 
attract  capital  to  possess  the  property  if  it  were  placed  on 
sale. 

Until  this  is  done,  book  values  cannot  express  real  value, 
nor  book  costs  express  true  costs  of  rendering  service. 


OPEN  DISCUSSION 


Mb.  James  E.  Allison,  Consulting  Engineer,  Former 
Public  Service  Commissioner,  St.  Louis,  Missouri: 

I  might  offer  a  word  to  clear  up  lack  of  agreement  in  term- 
inology, if  I  present  the  idea,  that  a  commission  can  not,  in 
rate  cases,  find  an  existing  value,  using  the  word  "value" 
as  exchange  value.  The  business  of  the  commission  is  to 
create  a  value,  not  to  find  an  existing  value.  There  is  no 
determinable  value  imtil  rates  are  established,  because  rates 
determine  returns  and  returns  determine  value;  but  a  com- 
mission can  try  to  create  a  value,  which  should  be  a  just 
amount, — an  amount  which  would  have  induced  the  crea- 
tion of  the  utUity.  This  amount  being  determined,  its  ex- 
change value  can  be  made  par  by  giving  it  the  proper  rate 
of  return. 


The  idea  that  commissions  or  courts  must  find  existing 
value  in  rate  cases  is  the  cause  of  a  great  part  of  our  present 
confusion ;  they  are  creating  a  value,  not  finding  it. 

Mr.  Eshleman: 

I  do  not  think  any  confusion  exists  among  the  speakers 
that  apparently  some  think  exists,  but  if  you  can  forget  all 
about  the  word  "value"  and  understand  that  we  are  trying 
to  find  out  an  amount  upon  which  earnings  should  be  allowed, 
or  an  amount  which  should  be  paid  when  we  purchase,  and 
remember  that  this  amount  has  no  more  to  do  with  value 
than  it  has  with  the  moons  of  Jupiter  or  Saturn,  whichever 
has  moons,  we  will  avoid  extra  talk  and  confusion.  There  is 
no  question  that  we  are  not  talking  about  value;  it  has  no 
place  in  this  discussion;  it  is  foreign  to  it. 


28 


THE      UTILITIES      MAGAZINE 


HOW  TO  GET  RID  OF  THE  REPRODUCTION  COST  THEORY 

By  G.  W.  Anderson 

Attorney-at-Law,  Boston,  Mass.,  formerly  Public  Service  Commissioner  of  Massachusetts 


THE  theory  of  reproduction  cost  as  a  basis  for 
rate  making  has  become  a  serious  public 
menace.  Little  time  need  now  be  spent  in 
pointing  out  its  fallacies,  absurdities  and  injustice. 
This  has  been  thoroughly  done  by  others.  It  is  enough 
now  to  refer  to  the  keen  and  caustic  analysis  of  this 
theory  by  Commissioner  Lane  in  the  Western 
Advanced  Rate  Case';  to  the  demonstration  of  its 
absurdity  and  injustice  by  Chairman  Stevens  in  the 
Buffalo  Gas  Case^;  and  in  the  Cataract  Case';  and  to  the 
unanswerable  criticism  of  it  in 
Commissioner  Max  Thelen's 
elaborate  paper  printed  in  the 
1913  report  of  the  Convention 
of  Railroad  Commissioners. 
Prof.  John  H.  Gray,  of  the 
University  of  Minnesota,  in  an 
address  before  the  Economic 
Club  of  San  Francisco  and 
elsewhere,  has  also  shown  how 
utterly  impossible  of  sound  and 
honest  administration  this  the- 


PART  II 
ORIGINAL    COST 


ory  IS.' 

This  theory  and  its  menace 
were  indeed  one  chief  cause  for 
creating  this  Utilities  Bureau 
to  assist  in  the  just  and  sound 
solution    of    utility    problems. 

The  topics  selected  for  this  conference  indicate  the 
serious  concern  this  theory  is  giving  to  all  who  desire 
fair,  equitable  and  stable  relations  established  between 
the  security-holders  of  our  utilities  and  the  using  and 
rate  paying  public. 

With  us  in  Massachusetts  the  theory  is  a  live  issue. 
Most  of  our  Massachusetts  gas  companies  have  large 
surpluses  derived  largely  from  excessive  rates  permitted 
by  the  regulating  commission  when  undue  fear  was 
felt  as  to  the  eflfect  of  prospective  electric  lighting  com- 
petition, besides  much  real  estate,  in  considerable  part 
not  used  for  gas  purposes.  Upon  all  these  surpluses 
and  upon  all  the  increasing  value  of  this  real  estate, 
the  gas  companies  are  now  claiming  the  constitutional 
right  to  have  a  return.  Our  Gas  Commission  has 
never  yet  conceded  this  claim,  but  their  rulings  indicate 
some  terror  of  the  theory. 

'  20  L.  C.  C. 

2  3  p.  S.  C,  2nd  Div.,  N.  Y.,  658. 

»  3  P.  S.  C,  2nd  Div.,  N.  Y. 

*  See  4  Am.  Econ.  Rev.  Supp.  1914,  p.  82. 


WHAT  IT  IS 

HOW  IT  CAN  BE  ASCERTAINED 

ITS  CONSTITUTIONALITY 

ITS  IMPORTANCE  AS  THE  CHIEF  BASIS  IN 

FAIR  VALUE 
THE  MASSACHUSETTS  IDEA: 

FAIR  RETURN  ON  ACTUAL  INVEST- 
MENT PRUDENTLY  AND  HONESTLY 
MANAGED 


The  lawless  and  wasteful  career  of  the  recent,  but 
now  deposed,  management  of  the  New  Haven  Railroad 
was  undoubtedly  prolonged  by  the  use  made  of  this 
reproduction  cost  theory  in  an  engineer's  report  made 
to  the  Validation  Commission  of  1910  (See  Mass.  Acts 
10,  Chap.  652),  adopting  the  most  excessive  form  of 
this  theory,  stating,  "Physical  valuation,  either  for 
purposes  of  justifying  the  rates  or  capitalization,  should 
fairly  allow  the  appreciated  value  of  real  estate  and 
any  otherT^elements  which  have  appreciated  without 

allowing  loss  for  depreciation 
of  elements  which  have  depre- 
ciated, provided  the  property 
is  maintained  in  good  condi- 
tion." Such  was  the  absurd 
basis  for  the  absurd  current 
report  that  the  New  Haven 
Railroad  had  a  surplus  of  over 
$100,000,000,  in  spite  of  its 
losses  of,  probably  $100,000,- 
000,  from  such  illegal  invest- 
ments as  the  Rhode  Island 
trolleys,  costing  the  New  Ha- 
ven over  $24,000,000,  while 
worth,  as  this  same  engineer 
found  (without  franchise), 
$2,440,679.  This  mythical  sur- 
plus of  $100,000,000  was  falsely 
published  in  financial  papers  in  the  pay  of  the  New 
Haven  as  a  finding  of  the  Validation  Commission  itself 
and  was  used  in  all  sorts  of  ways  to  conceal  from  the 
stockholders  and  from  the  public  the  enormous  and 
illegal  wastings  of  the  company. 

In  the  last  report  of  the  New  Haven's  President  to 
the  stockholders  for  the  year  ending  June  30,  1915 
(page  24),  he  says,  when  dealing  with  the  losses  suf- 
fered by  the  company  through  its  outside  investments, 
that  these  losses  have  not  yet  been  charged  off  to  profit 
and  loss,  but  that  the  directors  now  think  it  wise, 
"Simply  to  state  that  there  may  be  large  losses  which 
may  be  offset,  all  or  in  large  part,  by  proper  valuation 
of  the  property."  A  suit  is  now  pending  against  the 
former  management  to  recover  alleged  losses  of  $102,- 
000,000.  The  present  management  has  refused  to  carry 
on  this  suit.  In  this  report  of  the  President  we  now 
have  plain  notice  that  reproduction  cost  is  to  be  relied 
upon  to  offset  capital  lost  and  wasted  under  the  ad- 
ministration of  the  deposed  management. 


ORIGINAL      COST 


29 


It  is  disconcerting  to  find  this  notice  coming  just  as 
our  New  England  public  was  beginning  to  recreate  its 
utterly  shattered  confidence  in  the  soundness  and  wis- 
dom of  our  railroad  management.  It  declares  a  new 
war  on  the  rights  of  the  public.  Massachusetts  will 
never  willingly  accept  as  a  basis  for  rates  the  fantastic 
and  mythical  "values"  of  overpaid  and  highly  imagina- 
tive experts  as  a  substitute  for  honest  dollars  put  at  the 
public  service.  The  theory  has  thus  already  indirectly 
done  New  England  much  harm,  though  not  yet,  so  far 
as  I  know,  ever  there  officially  approved  and  enforced. 

In  the  brief  filed  with  the  Interstate  Commerce 
Commission  by  the  Railroad  Presidents'  Conference 
Committee  with  reference  to  the  basis  of  the  valuation 
now  being  made,  page  157,  et  seq.,  I  find  the  claim  that 
the  force  of  gravitation  that  makes  the  roadbed  solidify 
is  value  to  be  treated  as  the  practical  equivalent  of 
capital  contributed.  This  and  other  analogous  claims 
give  good  ground  for  the  hope  that  this  theory  may  yet 
find  its  death  in  the  extravagant  absurdities  of  its 
advocates. 

The  statement  in  Mr.  Whitten's  1914  supplement 
to  his  Valuation  of  Public  Service  Corporations,  Sec. 
1010,  "Little  progress  has  been  made  toward  a  defini- 
tion of  fair  value  for  rate  purposes"  is  absolutely  accur- 
ate. No  progress  can  be  made,  for  the  simple  reason 
that  value  rests  mainly  on  rates  and  rates  cannot 
therefore  be  based  on  the  value  that  rates  create.  The 
courts  waltz  dizzily  about  a  circle — valuation  to  rates, 
rates  to  valuation — and  arrive — nowhere.  It  is  a 
process  as  scholastic  and  fruitless  as  the  mythical 
inquiry  as  to  which  came  first — the  hen  or  the  egg. 

I  shall  indulge  in  no  extended  analysis  of  the  impos- 
sibihties  of  this  theory :  It  is  both  farcical  and  fraudu- 
lent. I  regard  both  its  logical  absurdity  and  its 
practical  inapplicability  as  demonstrated.  We  have 
now  reached  the  point  where  the  real  questions  are :  How 
to  get  rid  of  it.?  What  shall  we  substitute  for  it? 
These  important  questions  I  propose  to  treat  briefly, 
and,  as  I  am  fully  aware,  inadequately. 

As  soon  as  one  begins  an  analysis  of  the  principles 
and  forces  that  today  control  rate  making  in  this 
country,  he  is  struck  by  a  curious  anomaly.  The 
reproduction  cost  theory  is  entirely  an  outgrowth  of 
court  rulings  made  in  rate  cases.  No  legislature 
assisted  in  its  creation.  But  it  is  elementary  that  rate 
making  is  a  legislative  and  not  a  judicial  function.  This 
the  courts  constantly  reiterate.  For  instance,  in  the 
Minnesota  Rate  Case,  230  U.  S.  352,  433,  Mr.  Justice 
Hughes  says:  "The  rate-maJdng  power  is  a  legislative 
power  and  necessarily  implies  a  range  of  legislative  dis- 
cretion. We  do  not  sit  as  a  board  of  revision  to  substitute 
our  judgment  for  that  of  the  legislature  or  of  the  commission 


lawfully  constituted  by  it,  as  to  matters  within  the  province 
of  either." 

But  in  spite  of  constant  assertion  by  the  courts  of 
two  elementary  and  really  controlhng  doctrines:  (1) 
that  rate  making  is  a  legislative  and  not  a  judicial 
function,  and,  (2)  that  the  courts  have  nothing  to  do 
with  rate  making  except  to  prevent  their  being  used 
as  a  vehicle  of  robbery,  by  depriving  owners  of  public 
utiUties  of  their  property  without  due  process  of  law, — 
we  find  that  in  fact  neither  proposition  is  observed  by 
the  courts.  It  is  undeniable  that  in  the  United  States 
rates  are  today  made  by  the  courts.  Our  Supreme 
Court  is,  for  all  practical  purposes,  sitting  as  an  appel- 
late rate  making,  and  therefore  as  a  legislating,  body.^ 

The  result  of  this  assumption  by  the  courts  of  legis- 
lative functions  has  been  as  confusing  and  mischief- 
working  in  rate  regulation  as  analogous  encroachment 
was  found  in  master-and-servant  law.  In  both  in- 
stances the  courts  have  proved  very  poor  legislators. 
We  have  not  yet  forgotten  the  long  struggle  we  had 
in  getting  rid  of  bad  industrial-accident  laws  made  by 
the  courts.  It  will  be  remembered  that  a  considerable 
number  of  the  Judges  persistently  held  the  notion  that 
their  own  pet  economic  and  social  ideas  were  firmly 
embedded  in  the  Fourteenth  Amendment  and  therefore 
a  part  of  the  supreme  law  of  the  American  land.^ 

In  New  York  it  took  a  constitutional  amendment  to 
rescue  the  legislative  power  from  destruction  by  the 
judiciary.'  But  much  progress  has  been  made  during 
the  past  ten  years  in  bringing  the  courts  back  to  the 
same  and  necessary  recognition  of  the  limitations  of 
their  own  power,  which  some  of  them,  notably  Mr. 
Justice  Holmes,  have  always  held. 

In  Commonwealth  vs.  Perry,  155  Mass.  117,  decided 
in  1891,  Mr.  Justice  Holmes  dissented  from  the  decision 
of  the  majority  of  the  Massachusetts  Courts  holding 
the  Weavers'  Fine  bill  unconstitutional.  From  that 
year  down  to  the  present  he  has  frequently  recorded 
himself, — sometimes  in  a  minority  and  recently  more 
frequently  with  a  majority, — against  the  attempts  of 
the  courts  to  hold  unconstitutional  legislation  that 
they  did  not  approve  of.^ 

Without  indulging  in  an  elaborate  citation  and  analy- 
sis of  cases  which  cannot  be  reconciled,  it  is  enough  now 
to  say  that  the  tendency  of  recent  decisions  of  the 

'  See  Ripley's  Railroad,  Finance  and  Organization,  p.  316. 

2  Compare  Lochner  vs.  A'^.  Y.,  198  U.  S.  45;  Hoxie  vs.  N.  Y.,  N.  H.  &  H.  R. 
R.,  82  Conn.  356;  MvUer  vs.  Oregon,  208  U.  S.  412;  Employers  Liability 
Cases,  207  U.  S.  463;  Second  Employers  Liability  Cases,  223,  U.  S.  1;  Davis- 
Smith  Co.  vs.  Clausen,  65  Wash.  156;  Cunningham  vs.  N.  W.  Imp.  Co.,  44 
Mont.  180. 

'  Ives  vs.  Buffalo  &  R.  R.,  201  N.  Y.  271;  N.  Y.  Cons.,  Art.  I.  sec.  19;  In  re 
Jensen  53  N.  Y.  L.  J.  (July  28,  1915). 

*  Noble  State  Bank  vs.  Haskell,  219  U.  S.  104;  Mutual  Loan  Co.  vs.  Martell, 
200  Mass.  482;  S.  C,  222  U.  S.  225;  German  &c.  Ins.  Co.  vs.  Kansas,  233 
U.  S.  389. 


30 


THE      UTILITIES      MAGAZINE 


Supreme  Court  of  the  United  States  is  back  towards 
the  old  and  sound  principle  of  leaving  the  legislature  to 
perform  its  own  functions,  holding  unconstitutional 
only  legislation  which  is  plainly  obnoxious  to  the  Con- 
stitution. This  tendency  towards  sound  principle 
will,  if  supplemented  by  proper  enactments  by  the 
legislature,  be  found  exceedingly  helpful  in  solving 
the  rate-making  problem,  as  it  was  recently  found 
helpful  in  giving  us  Compensation  Acts  and  putting 
our  industrial  accident  business  on  a  basis  humane, 
just,  and  capable  of  efficient  and  economical  admin- 
istration. 

It  is  an  utter  waste  of  time  to  attempt  to  analyze 
and  reconcile,  even  to  read,  many  of  the  lower  court 
decisions.  Most  of  them  are  not  helpful  to  a  fair 
understanding  either  of  constitutional  law  or  of  sound 
public  policy.' 

Doubtless  there  are  troublesome  dicta  in  some  of  the 
Supreme  Court  opinions, — such  as  the  statement  in 
the  New  York  Case  concerning  a  6  per  cent  return  and 
the  inclusion  of  a  value  for  the  franchise  because  of  its 
recognition  by  state  authorities.  But  the  decision  in 
that  case  was  a  dismissal  of  the  bill,^ — a  vindication  of 
the  legislature's  control  of  rate  making.^  The  decision 
in  Cotting  vs.  Kansas  City  Stock  Yards  Co.,  183  U.  S., 
p.  79,  may  prove  difficult  to  reconcile  with  any  work- 
able theory.  But  even  if  the  Supreme  Court  should 
find  itself  required  to  overrule  this  decision,  this  will 
be  nothing  more  than  has  already  been  done,  in  effect, 
as  to  the  doctrine  in  the  Munn  Case,  94  U.  S.,  that  the 
remedy  for  unfair  rates  is  at  the  polls  and  not  in  the 
courts.  That  court  had  rather  be  right  than  to  be  con- 
sistent. But  few,  if  any,  of  the  actual  decisions  of  the 
Supreme  Court  stand  in  the  way  of  the  enactment  of 
legislation,  constitutionally  sound  as  well  as  expedient 
and  workable,  dealing  with  the  proper  relations  be- 
tween holders  of  securities  in,  and  rate-payers  to,  public 
utility  companies. 

The  main  difficulty  has  grown  far  less  out  of  any 
actual  or  apparent  purpose  of  the  courts  to  encroach 
upon  the  legislative  field  than  out  of  the  failure  of  the 
legislature  adequately  to  occupy  its  field  and  perform 
its  legislative  functions.  The  problem  that  the  courts 
faced,  or  thought  they  faced,  was  the  question  as  to 
whether  the  aggregate  result  of  legislatively-made 
rates  was  confiscatory.  Now  the  legislatures  of  most 
of  the  states  left  this  problem  to  be  determined  by  the 
courts  with  no  basis  prescribed  for  that  determination. 
This  failure  of  the  legislatures  to  determine  for  the 
courts  the  basis  for  computing  left  the  courts  flounder- 
ing in  a  morass  of  chaotic  corporation  laws  and  attempt- 

i  C.  R.  R.  Ga.  vs.  R.  R.  Com.  161  Fed.  925;  L.  &  N.  R'y  vs.  R.  R.  Com., 
196  Fed.  800;  S.  C,  225  U.  S.  430. 
^Wilcox  vs.  Cmu.  Gas  Co..  212  U.  S..  p.  19. 


ingtodeal  with  the  confiscatory  or  non-confiscatory  char- 
acter of  rates  of  public  utility  companies  capitalized 
by  every  conceivable  kind  of  inconsistent  and  confusing 
financial  method.  It  really  left  them  to  make  rates, 
just  as  the  courts  have  always  had  to  make  rates  when 
the  reasonableness  of  any  charge  made  in  any  business 
affected  with  a  public  interest  has  come  before  the 
court  for  determination. 

At  first  the  attempt  was  made  to  induce  the  court  to 
protect  the  securities  outstanding,  however  little  they 
represented  either  investments  or  "value,"  determined 
by  any  sort  of  method.  This  monstrous  doctrine  the 
courts  refused  to  accept  in  the  famous  case  of  Smythe 
vs.  Ames,  169  U.  S.  But  unfortunately  in  repudiating 
this  palpably  dishonest  theory  for  testing  the  confisca- 
tory character  of  a  schedule  of  rates,  the  court  uttered 
dicta  which  have  in  practice  proved  the  chief  foundation 
of  the  reproduction-cost  theory,  which,  if  adopted  with 
all  its  present  claims,  would  probably  be  more  obnoxious 
and  unworkable  than  the  outstanding  security  theory. 

But  the  point  now  to  be  emphasized  is  that  in  dealing 
with  this  assumed  duty  of  testing  the  alleged  confisca- 
tory character  of  a  schedule  of  rates  the  court  had  to 
determine  its  own  basis,  because  the  legislature  had  not 
performed  that  part  of  its  rate  making  functiori.  In 
the  light  of  experience,  it  is  probable  that  the  courts 
have  done  far  more  harm  than  good  in  intervening  at 
all  to  prohibit  alleged  confiscatory  rates.  Confiscatory 
legislation  is  like  bigamy, — a  crime  that  carries  its 
own  punishment.  But  after  the  courts  had,  wisely  or 
unwisely,  assumed  this  function,  they  found  they  had 
no  adequate  means  of  performing  it.  (Compare  the 
language  of  Mr.  Justice  Gray  in  Dow  vs.  Beidelman, 
125  U.  S.  680.)  The  next  step  was  to  say  that  the 
basis  was  the  "fair  value  of  the  property  used."  This 
sounded  well,  but  has  been  found  on  analysis  to  mean 
nothing.  The  natural  result  is  that  reproduction  cost 
has  been  pushed  forward,  mainly  by  speculatively 
inclined  corporation  managers  as  a  plausible  theory 
for  determining  "fair  value," — a  plan  which,  if  success- 
ful, would  in  these  days  of  increasing  prices,  work  out 
the  most  gigantic  stock-watering  scheme  ever  devised 
by  the  ingenuity  of  man. 

But  the  points  that  I  would  now  make,  repeat  and 
emphasize  are  these: 

(1)  Rate  making  is  a  legislative  and  not  a  judicial  function. 
This  is  still  asserted  by  the  Supreme  Court  notwithstanding 
its  contrary  practice;  and  the  decisions  of  that  court  furnish 
good  ground  to  beUeve  that  the  court  would  welcome  an 
opportunity  to  be  relegated  to  the  performance  of  judicial 
functions  only. 

(2)  The  interference  of  the  courts  is  solely  for  the  purpose 
of  preventing  confiscation, — to  prohibit  the  states  from  de- 


ORIGINAL      COST 


31 


priving  security  holders  of  their  property  rights  without  due 
process  of  law. 

(3)  In  dealing  with  alleged  confiscatory  legislation,  the 
courts  asserted  the  fair  value  basis  of  rates  because  the 
legislatures  had  failed  to  provide  any  basis  at  all. 

(4)  "Fair  value  as  a  basis,"  proving  in  practice  a  mean- 
ingless euphemism,  has  laid  a  specious  and  plausible  founda- 
tion for  the  reproduction  cost  theory. 

(5)  Now  if  these  propositions  are  sound,  the  way  to  get 
rid  of  the  reproduction  cost  theory  is  for  the  legislatures  to 
finish  their  incomplete  undertaking  of  rate  making, — -that 
is,  declare  a  basis  upon  which  the  aggregate  net  return  shall 
be  computed. 

I  reiterate  that  a  fair  analysis  of  the  decisions  of  the 
Supreme  Court  shows  that  the  door  is  wide  open  for 
the  legislatures  to  resume  the  rate  making  powers 
which  the  courts  say  belong  to  the  legislatures  but 
which  the  courts  are  in  fact  themselves  exercising. 

Now  it  is  agreed  that  the  sole  function  of  the  courts 
(apart  from  some  express  statutory  jurisdiction  quite 
distinct  from  the  present  inquiry),  is  to  prevent  con- 
fiscation. But  what  does  this  really  mean?  Confis- 
cation of  what  property,  and  belonging  to  whom? 
This  is  a  concrete  question  not  an  abstract  one.  Wliose 
rights  is  it  that  the  courts  have  under  the  Fourteenth 
Amendment  undertaken  to  protect  by  due  process  of 
law?  Obviously,  the  rights  of  the  holders  of  the  securi- 
ties (in  ordinary  practice  stocks  only)  in  public  utility 
companies.  It  is  not  the  property  of  the  company  as 
such,  that  the  court  is  interested  in  protecting;  it  is 
only  the  property  of  the  holders  of  the  securities  issued 
by  the  company.  But  in  Smythe  vs.  Ames,  169  U.  S., 
the  court  refused  to  protect  those  securities  simply 
because  they  were  outstanding  when  they  bore  little 
or  no  relation  either  to  original  investment  or  to  the 
value  of  the  property  determined  upon  any  arguable 
theory.  Yet  it  is  undeniable  that  the  persons  whose 
rights  are  the  just  objects  of  the  court's  solicitude  are 
the  stockholders  of  our  utility  companies.  It  is  they 
and  they  alone  who  are  deprived  of  their  just  rights 
when  the  legislature  without  due  process  makes  rates 
inadequate  to  furnish  a  just  return. 

In  truth,  then,  all  that  due  process  of  law  requires  is 
that  the  rate  payers,  who  may  be  assumed  to  be  the 
majority,  shall  not,  through  their  control  of  the  legis- 
lature, rob  the  security  holders  whose  property  the 
rate  payers  have  obtained  the  use  of. 

But  what  property  have  the  rate  payers  obtained 
the  use  of?  Manifestly  the  property  that  the  investors 
put  into  the  public  utilities. 

The  basic,  lasting  and  controlling  factors  as  to  rate 
making  are  the  relations  between  the  rate  payer  and 
the  investor.  The  legal  necessity  of  creating  a  cor- 
porate machine  to  hold  title  to  the  property  purchased 


by  the  investors'  money  and  used  for  the  rate-payers' 
convenience,  is  of  minor — almost  negligible  importance. 
The  future  of  privately  owned  and  managed  utilities 
is  not,  as  some  assert,  "bound  up  in  valuation."  It 
is  bound  up  in  credit, — ability  to  get  capital  at  fair 
rates.  They  are  constant  capital-seekers.  Their  pro- 
moters and  managers  are  nothing  but  middlemen 
seeking  to  bring  investors  and  rate  payers  into  safe 
and  satisfactory  business  relations.  If  these  managers 
join  the  will-o'-the-wisp  chase  for  speculative  reproduc- 
tion cost  values,  they  will  find  themselves  sooner  or  later 
discredited  participants  in  a  fraudulent  game. 

The  true  function  of  these  promoters  and  managers 
is  so  to  intervene  between  investors  (producers)  and 
rate-payers  (consumers)  as  to  establish  and  maintain 
honest,  just  and,  therefore,  satisfactory,  relations  be- 
tween these  two  chief  parties  to  the  utility  enterprise. 

For  the  sake  of  their  personal  reputation,  utility 
managers  should  at  once  abandon  the  reproduction 
cost  theory  as  utterly  dishonest.  Public  advantage 
and  private  interest  both  demand  that  utility  managers 
should  so  perform  their  duties  as  to  have  and  be  entitled 
to  have  the  general  respect  and  confidence  of  the  com- 
munity. The  country  has  not  yet  forgotten  the 
scandals  of  the  Chicago  Railways,  of  the  New  York 
City  Railways,  the  New  Haven  fiasco  and  the  Rock 
Island  receivership.  It  must  be  admitted  that  as 
the  situation  now  is  these  managers  cannot  as  a  class 
afford  to  lose  any  reputation.  The  many  sound- 
thinking  and  fair-dealing  men  at  work  in  the  public  util- 
ity field  should  jealously  guard  that  field  from  further 
encroachment  by  speculators,  manipulators,  exploiters 
of  legislatures  and  other  public  nuisances.  The  public 
needs  the  best  men  in  this  field.  Good  men  now  at 
work  there  should  realize  that  their  real  enemies  are 
some  of  their  own  colleagues  and  associates,  not  the 
regulating  commissions  nor  any  set  of  outside  critics. 
These  utility  managers  must  see  their  problem  in 
right  perspective.  They  must  fully  understand  that 
their  proper  field  is  that  of  investment  and  develop- 
ment, not  that  of  exploitation  and  speculation.  They 
are  agents.  They  must  realize  who  their  principals 
really  are,  or  they  will  find  themselves  guilty  of  gross 
and  disgraceful  breaches  of  trust.  They  cannot 
advocate  the  reproduction-cost-theory  and  faithfully 
serve  their  real  principals,  viz.: — the  investors  and  the 
rate-payers. 

For  what  does  the  community  really  ask  of  private 
investors  when  it  offers  a  franchise  for  the  creation  of  a 
public  utility?  Two  things, — and  only  two  things: 
Money  and  management.  It  does  not  ask  that  private 
investors  furnish  lands  or  rails  or  engines  or  gas  pipes, 
or  other  implements.  It  asks  for  capital  and  the 
management  of  that  capital.    The  lands  and  rails  and 


32 


THE      UTILITIES      MAGAZINE 


other  implements  are  but  the  secondary  results  of  the 
devotion  of  the  investors'  money  to  a  public  purpose. 
Except  within  narrow  limits  the  investors  and  their 
selected  managers  have  no  choice  as  to  the  form  that 
their  investments  may  take.  They  must  locate  the 
terminals  and  roadbed  of  the  railroads  as  the  public 
interest  and  convenience  require.  They  may  be  com- 
pelled to  build  a  station  here  and  to  abandon  one  there. 
If  the  abandoned  site  has  to  be  sold  at  a  loss,  who 
should  stand  the  loss.f*  Obviously,  the  public  whose 
changing  needs  or  desires  caused  it.  They  must  from 
time  to  time  adopt  such  provisions  for  the  public  safety 
and  convenience  as  progress  in  the  art  and  the  public 
demands  require  of  them.  They  must  buy  copper 
when  the  public  needs  it  whether  it  cost  25  cents  a 
pound,  or  half  that  price. 

If  the  proposition  that  all  that  private  investors 
furnish  these  public  utility  companies  is  money  and 
management  be  sound,  it  follows  that  all  that  the 
court  in  the  performance  of  its  anti-confiscatory  duties 
has  to  do,  is  to  prevent  the  confiscation  of  that  which 
is  furnished. 

The  fatal  defect  in  the  rulings  that  the  courts  have 
made  is  that  they  have  failed  to  see  that  what  the 
investors  furnished,  viz., — money,  and  not  what  they 
did  not  furnish,  viz.,  the  ephemeral  and  changing  results 
of  the  investment  of  that  money,  was  the  property 
entitled  to  protection  from  confiscation. 

Test  the  question  in  this  way:  Suppose  a  town  de- 
sires a  water  system, — is  unwilling  to  finance  it  on  the 
public  credit  and  have  it  managed  by  its  town  officials; 
that  adequate  private  capital  cannot  be  interested 
because  of  the  fear  that  the  cost  of  the  plant  will  be 
so  great  that  sufficient  takers  paying  adequate  rates 
cannot  be  obtained  to  make  a  fair  return.  There- 
upon, the  town  offers  to  contribute  in  land  or  other 
property,  say,  one  third  of  the  original  cost  of  the  plant 
in  order  to  induce  investors  to  put  up  the  other  two 
thirds.  Suppose  the  charter  explicitly  provides  that 
a  fair  return  shall  be  reckoned  only  upon  the  two  thirds 
of  the  capital  furnished  by  private  investors.  Is  such 
a  statute  constitutional?  Can  the  Constitution  of 
the  United  States  prevent  American  communities  from 
creating  privately  owned  and  managed  public  utilities 
under  charters  that  limit  the  return  to  investors  to  the 
amount  of  their  investment?  Clearly  not.  Now  if 
this  proposition  is  sound  as  to  a  prospective  utility,  it  is 
sound  as  to  an  existent  utility,  unless,  out  of  the  historic 
facts  surrounding  the  granting  of  the  charter  and  the 
payment  of  the  capital,  is  to  be  deduced  an  express  or 
implied  contract  that  the  investors  therein  were  to 
have  a  return,  not  only  upon  their  own  investment, 
but  upon  land  grants  and  other  contributions  from  the 
public  treasury. 


Of  course  I  am  not  now  arguing  that  charters  are  to 
be  construed  as  vesting  in  their  holders  a  constitutional 
right  to  make  their  own  rates  or  to  be  free  from  legis- 
lative control.  But  there  is  a  clear  distinction  between 
this  claim  that  the  creature  of  the  legislature  is  greater 
than  the  creator,  and  the  proposition  that  I  urge, — 
which  is  that  the  property  which  is  entitled  to  con- 
stitutional protection  is  the  property  which  was  fairly 
understood  to  be  devoted  to  the  public  use.^ 

It  is  well  settled  law  that  the  title  under  which  a 
public  utility  company  holds  its  property  falls  far 
short  of  being  a  full  property  right.  One  of  the  ordi- 
nary incidents  of  property  is  the  right  to  lease,  sell  or 
exchange  it.  But  a  public  utility  company  can  neither 
sell  nor  lease  its  property  used  for  the  pubhc  without 
legislative  authority.  See  Central  Transportation  Co. 
vs.  Pullman  Palace  Car  Co.,  39  U.  S.  24,  in  which  there 
is  an  elaborate  and  learned  discussion  by  Mr.  Justice 
Gray.  It  cannot  abandon  its  public  duties.  Atty. 
Gen.  vs.  Haverhill  Gas  Light  Co.,  215  Mass.  394. 

Nor  is  the  familiar  rule  that  "every  public  grant 
.  .  .  .  of  privileges  or  franchise,  if  ambiguous, 
is  to  be  construed  against  the  grantee  and  in  favor  of 
the  public"  (139  U.  S.  p.  24)  to  be  overlooked  when 
determining  the  question  as  to  whether  the  property 
of  a  public  utility  entitled  to  a  return,  includes  merely 
the  investments  made  for  the  public  benefit,  or 
other  property  from  pubhc  grants,  unearned  increment 
derived  from  excess  earnings. 

The  rate  decisions  of  the  Supreme  Court  which  have 
made  us  trouble  are  not  based  upon  the  constitutional 
prohibition  that  no  state  shall  pass  a  law  impairing  the 
obligation  of  contracts,  they  are  all  based  upon  the 
provision  that  states  shall  not  deprive  persons  of  their 
property  without  due  process  of  law. 

The  fallacy  in  this  reasoning  seems  to  me  to  lie  in 
the  assumption  that  security  holders  of  a  public  utility 
company  have  a  property  right  to  draw  from  rate 
payers  a  return  upon  something  the  seciu-ity  holders 
have  never  furnished.  They  furnished  money, — capi- 
tal; nothing  else,  except  management. 

There  is  a  vital  distinction  between  the  property 
right  that  a  public  utility  company  has  in  its  lands 
when  they  are  taken  from  it  by  right  of  eminent  domain 
and  the  property  right  that  a  corporation  has  in  being 
entitled  to  levy  such  rates  as  shall  not  deprive  the 
security  holders  of  what  the  security  holders  furnished 
to  the  corporation  for  the  public  convenience.  Failure 
to  realize  and  enforce  this  distinction  is  the  chief  source 
of  our  present  troubles.  Of  course,  if  nation,  state  or 
town  deeds  land  to  a  public  utility  company,  the  com- 
pany owns  the  land  and  can  collect  its  full  value  if  the 
land  is  taken  away.     Yet,  until  the  government  by 

'  (Compare  Cooky's  Constitutional  Limilations,  page  391  and  cases.) 


ORIGINAL   COST 


33 


such  taking  waives  its  right  in  such  property  derived 
from  its  original  devotion  to  the  public  service,  the 
owners  thereof  have  but  a  limited  and  qualified  property 
right  in  it.  The  right  to  charge  rates  upon  the  value 
of  such  donated  land,  if  it  exists  at  all,  must  grow  out 
of  the  franchise, — an  express  or  implied  contract,  the 
burden  of  showing  which  is  upon  the  corporation  and 
not  upon  the  donor  of  the  gifts.  No  such  right  can 
be  deduced  from  the  mere  fact  of  the  gift, — rather  the 
contrary;  and  "unearned  increment"  is  social  property 
— a  gift. 

In  proper  perspective,  it  is  a  strange  doctrine  that 
American  communities  cannot  make  gifts  to  their 
public  utility  companies  without  thereafter,  in  per- 
petuity, being  taxed  upon  the  assumed  increasing  value 
of  these  gifts.  Yet  this  is  probably  the  practical 
effect  of  the  decision  of  the  Court  in  the  Minnesota 
Rate  Case,  230  U.  S.,  as  to  railroads  which  were  brought 
into  existence  largely,  if  not  wholly,  because  of  enor- 
mous gifts  of  public  property  made  to  their  promoters. 
Can  any  one  doubt  that  if  at  the  time  of  the  chartering 
of  the  railroads,  whose  rates  were  reviewed  in  the 
Minnesota  Rate  Cases,  the  charters  had  provided  that 
reasonable  rates  should  be  deemed  such  rates  as  would 
make  a  fair  return  only  upon  the  amount  of  capital 
put  into  the  enterprise  by  the  security  holders,  and 
excluding  all  capital  derived  from  public  gifts, — ^the 
Supreme  Court  would  have  held  such  a  charter  valid? 

But  unless  such  a  charter  as  this  is,  ab  initio,  uncon- 
stitutional, then  the  real  constitutional  question  as  to 
the  rates  of  existing  utilities  is,  whether  there  is  any- 
thing in  the  history  of  the  relations  of  the  investors  in 
these  utilities  to  the  chartering  government,  which 
now  prevents  the  court  from  saying  that  the  return 
shall  be  calculated  only  upon  the  actual  investment 
made  for  the  public  benefit.  I  find  no  case  which  leads 
me  to  think  that  the  Supreme  Court  will  hold  uncon- 
stitutional as  confiscatory  a  legislative  enactment,  to 
the  effect  that  only  capital  honestly  and  prudently 
invested  shall,  under  normal  conditions,  be  taken  as  the 
basis  of  calculating  a  return  in  order  to  fix  fair  and 
reasonable  rates. 

Put  otherwise:  The  community  that  asks  for  and 
obtains  privately  capitalized  and  managed  public 
utilities,  hires  money  and  management  as  truly  as  if  it 
borrowed  the  money  and  employed  the  managers  on 
salaries.  The  two  contrasted  systems  of  public  owner- 
ship or  private  management,  plus  private  control,  are 
distinguished  only  in  minor  matters  and  in  degree. 
(Cf.  Chi.  etc.  R'y  Co.  vs.  Minn.,  134  U.  S.  418,  461.) 
It  is  merely  a  question  of  which  method  will  give  us 
the  safest,  cheapest,  best  and  most  progressively  man- 
aged utilities.  We  may  pay  more  in  percentage  for 
private  money  than  if  borrowed  on  public  credit.     We 


may  stand  for  higher  salaries  to  managers  of  privately 
owned  public  utilities.  But  the  basis  of  the  rates  is 
the  same:  We  must  pay  for  what  we  get, — money  and 
management.  Of  course  in  the  payment  for  money 
may  be  included  risk  of  loss;  if  we  refuse  to  pay  for 
that  we  shall  not  get  the  money.  That  is,  we  must 
allow  rates  that  will  put  and  keep  our  utilities  in  good 
credit.  But  there  is  no  obligation  in  ethics  or  in  busi- 
ness policy  to  pay  for  something  that  is  not  furnished. 
But  there  is  obligation  to  pay  for  what  is  furnished; 
and  the  reproduction  cost  theory,  logically  applied, 
throws  unfair  risks  and  losses  upon  the  investors  and 
tends  to  discourage  the  promotion  of  new  and  needed 
public  utilities.  Most  new  utilities  have  a  period, 
pending  the  building  up  of  the  business,  when  the  re- 
production cost  is  much  less  than  the  honest  and 
reasonably  prudent  investment.  Are  their  rates  to  be 
cut  to  this  basis — thus  throwing  the  loss  permanently 
on  the  investors?  Or,  rather,  do  sound  policy  and  fair 
dealing  both  require  that  the  investors  in  a  needed  and 
finally  succeeding  utility  have  their  money  all  back 
with  a  fair  return? 

Moreover,  this  reproduction-cost-theory  deals  only 
with  the  ephemeral — ^the  conditions  of  the  fleeting 
moment;  the  relations  between  investing  public  and 
rate  paying  public  are  of  the  permanent  and  funda- 
mental kind.  Our  utility  companies  are  not  finished. 
They  are  in  process, — constantly  calling  for  new  capital. 
They  must  be  kept  on  good  trading  terms  with  the 
investing  public,  or  the  whole  experiment  of  private 
ownership  and  public  regulation  of  public  utilities  will 
fail.  Obsolescence  and  other  forms  of  depreciation 
are,  broadly  speaking,  not  burdens  of  the  investor;  the 
rate-payer  must  bear  them.  Within  the  limits  of  sound 
management  and  the  ordinary  risks  of  the  enterprise, 
investors  must  be  protected  or  the  community  will  go 
without,  or  pay  a  high  price  for,  capital  for  its  utilities. 

Moreover,  if  reproduction-cost  is  the  test,  the  in- 
vestors will  shortly  be  shocked  to  find  it  will  be  repro- 
duction of  equivalent  service,  not  of  the  identical  plant 
with  its  frequently  undesirable  location  and  obsolescent 
or  partially  obsolescent  appliances.  Who  would  today 
locate  Boston's  Railroad  terminals  where  they  now  are? 
What  was  the  reproduction  value  of  horse  railways 
when  the  success  of  the  trolleys  became  certain?  The 
experience  of  the  New  Haven  Railroad  in  attempting 
to  market  the  abandoned  Park  Square  terminal  site, 
shows  how  ridiculous  the  claims  for  land  values  are. 
At  the  end  of  seventeen  years  the  New  Haven  has  not 
been  able  to  sell  it,  and  carrying  cost  and  taxes  must 
have  wiped  out  the  book  value  of  more  than  $5,000,000. 

Unless  we  adopt  and  maintain  as  a  fundamentally 
guiding  principle  the  duty  and  policy  of  protecting 


34 


THE      UTILITIES      MAGAZINE 


investments  honestly  and  prudently  made  and  wisely 
managed,  we  make  our  regulation  a  fraud  or  a  farce. 

_0f  course  I  am  arguing  only  for  a  fundamental  and 
guiding  principle.  Rate  making  is  too  complex  and 
difficult  a  problem  to  be  capable  of  solution  by  any 
absolute  or  mathematical  test.  Competition  will 
sometimes  make  a  fair  return  on  capital  invested 
impossible.  In  other  cases  an  exceedingly  generous 
return  must  be  allowed  on  a  fortunately  situated  utility, 
like  the  Lake  Shore  Railroad, — else  its  rates  will  be  so 
low  as  to  give  it  an  undue  portion  of  the  business  and 
thus  destroy  needed  competing  lines. 

There  is,  there  can  be,  no  answer  to  the  proposition 
so  ably  urged  by  Commissioner  Thelan  and  Professor 
Gray  that  the  essence  of  sound  relations  between  public 
and  public  utility  is  that  of  principal  and  agent.  No 
other  theory  is  honest  or  workable  or  permanent. 

Nor  am  I  able  to  accept  the  doctrine  which  Chairman 
Stevens  of  the  New  York  Up-state  Commission  has  set 
forth  in  several  opinions,  practically  to  the  effect  that 
every  rate  determination  is  on  final  analysis  nothing 
but  a  personal  judgment  of  what  is  fair.  This  amounts 
to  saying  that  rate  making  is  the  output  of  "a  govern- 
ment of  men  and  not  a  government  of  laws."  Apart 
from  the  grave  doubt  one  feels  as  to  whether  the  legis- 
lature may  constitutionally  delegate  such  arbitrary 
power,  such  actual  or  assumed  delegation  makes  the 
position  of  a  commission  altogether  too  powerful  for 
believers  in  a  democratic  "government  of  laws"  to 
tolerate.  It  is  quite  practicable  to  lay  down  a  funda- 
mental guiding  principle,  flexible  enough  so  that  the 
administrative  commission  may  deal  with  the  excep- 
tional case,  and  controlling  enough  so  that  investors  and 
rate-payers  may  fairly  understand  the  essence  of  their 
interrelations. 

But  my  suggestion  that  the  way  to  get  out  of  the 
slough  into  which  we  have  been  plunged  by  the  Supreme 
Court's  rulings,  or  more  accurately  its  dicta, — is 
through  legislation, — is  not  without  support  in  actual 
experience. 

In  Massachusetts  we  have,  or  think  we  have,  full  and 
adequate  legislation  as  to  the  basis  upon  which  rates 
are  to  be  reckoned.  At  any  rate  in  the  Middlesex  and 
Boston  Rate  Case,  decided  by  the  Public  Service  Com- 
mission of  Massachusetts  on  October  28,  1914,^ — the 
first  important  rate  case  decided  by  that  Commission 
under  the  new  and  adequate  powers  given  by  statute 
of  1913,  Ch.  784,  the  Commission  rules,  "Under  Massa- 
chusetts law  capital  honestly  and  prudently  invested 
must,  under  normal  conditions,  be  taken  as  the  control- 
ling factor  in  fixing  the  basis  for  computing  fair  and 
reasonable  rates;  that  if  there  is  mismanagement  caus- 


ing loss,  such  loss  must  be  charged  against  the  stock- 
holders legally  responsible  for  the  mismanagement."' 

It  fell  to  my  lot  to  write  that  opinion.  But  the 
doctrine  then  laid  down  was,  as  the  opinion^sets  forth, 
nothing  new  in  the  theory  of  Massachusetts  rate  regu- 
lation. For  nearly  a  century  Massachusetts  law  has 
gone  upon  the  theory  that  the  capitalization  of  public 
utility  companies  should  be  limited  to  the  actual  capital 
invested,  and  that  rates  must  be  figured  for  a  fair 
return  upon  the  capitalization. 

These  Massachusetts  enactments  relative  to  the 
basis  of  rates  are  either  constitutional  or  unconstitu- 
tional. They  have  never  been  held  unconstitutional. 
Our  utility  managers  and  their  counsel  urge  the  repro- 
duction-cost theory  in  their  rate  cases  when  representing 
excessively  prosperous  companies  like  some  of  our 
gas  companies.  But  so  far  no  case  involving  the  ques- 
tion of  the  validity  of  the  Massachusetts  code  has  ever 
reached  the  Supreme  Court  of  the  United  States.  In 
my  confident  belief,  if  and  when  the  validity  of  our 
legislation  does  come  before  the  Supreme  Court,  it  will 
be   held   constitutional. 

My  statement  of  Massachusetts  law,  embodied  in 
the  ruling  in  the  Middlesex  and  Boston  Rate  Case, 
above  quoted,  is  based,  as  the  opinion  will  show,  upon 
the  fair  and  necessary  inference  from  a  long  course  of 
Massachusetts  legislation  relative  to  the  capital  and 
rates  of  public  service  corporations. 

But  there  is  no  great  difficulty  in  inserting,  both  in 
the  interstate  commerce  act  and  in  the  acts  of  the 
various  states,  dealing  with  rate  making,  a  substan- 
tially equivalent  provision,  presenting  the  constitu- 
tional question  in  narrow  compass.  All  these  acts 
contain  provisions  to  the  effect  that  the  utility  may 
make  "charges  which  shall  be  just  and  reasonable." 
(See  Interstate  Commerce  Act,  Seel.)  Most  of  them 
also  contain  provisions  authorizing  the  regulating  com- 
mission, on  its  own  motion  or  by  complaint,  to  deter- 
mine what  rates  are  "just,  fair  and  reasonable  to  be 
thereafter  followed."  Others  fix  simply  maximum 
rates.     Interstate  Commerce  Act,  Sec.  15. 

In  our  Massachusetts  PubUc  Service  Act, — Acts  of 
1913,  Ch.  784,  Sec.  22, — is  a  careful  provision  authoriz- 
ing the  Commission  after  hearing,  either  upon  its  own 
motion  or  upon  complaint,  to  deal  with  rates,  whether 
unjust  and  discriminatory  or  unduly  preferential  from 
the  standpoint  of  the  rate-payer,  or  whether  from  the 
standpoint  of  the  carrier  "insufficient  to  yield  a  rea- 
sonable compensation  for  the  service  rendered."  The 
ruling  made  in  the  Middlesex  and  Boston  Rate  Case, 
supra,  as  an  inference  from  various  statutes  may  easily 
be  put  into  a  distinct  single  enactment,  as  follows : 

'  2  P.  S.  C.  (Mass.)  Ill,  112. 


ORIGINAL      COST 


35 


"The  Commission  shall,  for  the  purpose  of  determining 
whether  the  aggregate  return  derived  from  rates,  fares  and 
charges  is  sufficient  to  yield  a  reasonable  compensation  for 
the  service  rendered  by  any  public  utility,  take  as  the  con- 
trolling factor  under  normal  conditions  for  computing  the 
basis  of  such  rates  the  amount  of  cash  capital  paid  into  the 
treasury  of  such  utility  company  for  securities  lawfully 
issued, — provided  that  the  proceeds  of  such  securities  shall 
have  been  used  honestly  and  with  reasonable  prudence  in 
providing  the  facilities  of  such  utility." 

I  do  not  say  such  a  statute  would  cover  every  rate 
case  and  reduce  it  to  a  single  question  of  computing  a 
5  per  cent  or  6  per  cent  rate  on  an  investment  shown 
clearly  and  accurately  in  the  bookkeeping.  But  this 
is  the  sound  principle;  the  ideal  to  which  rate  regulation 
should  tend.  It  is  honest  and  easily  understood.  It 
may  be  simply  and  cheaply  administered;  for  which 
reason  many  experts  and  lawyers  will  disapprove  it. 

Lest  I  be  misunderstood,  I  repeat :  not  for  a  moment 
do  I  cherish  the  delusion  that  rate  making  can  be  re- 
duced to  a  simple  problem  in  percentage.  Even  if  we 
have  the  proper  standard — the  guiding  principle — ^for 
which  I  argue,  rate  making  is  still  a  complicated  and 
difficult  problem,  an  accurate  and  entirely  satisfactory 
solution  of  which  will,  in  very  many  cases,  be  found 
entirely  impossible.  This  would  be  true  even  if  all  our 
corporations  had  been  originally  capitalized  honestly 
and  with  reasonable  prudence,  and  if  the  subsequent 
bookkeeping  were  substantially  accurate.  In  fact,  as 
everyone  knows,  very  few  of  our  public  utilities  were 
well  born  and  well  brought  up.  Their  financial  history 
is  as  chaotic  and  hard  to  follow  or  understand  as  the 
political  history  of  the  Balkan  States. 

It  is  quite  possible  that  the  federal  valuation  now 
under  way  may  be  found  a  necessary  condition  prec- 
edent to  the  establishment  of  any  standard  from  which 
to  start  for  an  orderly  future.  In  view  of  the  enormous 
expense  of  this  valuation,  I  hope  it  may  serve  this  use- 
ful purpose.  I  can  conceive  of  no  other  respect  in 
which  it  is  likely  to  be  of  substantial  value.  Unless 
from  the  final  results  are  eliminated  practically  all 
elements  of  the  reproduction — cost  theory,  the  money 
spent  in  this  enterprise  will  be  worse  than  wasted. 

Again,  I  concede  that  in  making  rates  some  considera- 
tion must  be  given  to  the  amount  of  securities  that 
have  been  issued  and  sold  to  the  investing  public. 
Such  situations  as  the  Supreme  Court  found  in  the 
New  York  Gas  Case,  where  several  millions  of  capital 
had  been  issued  for  the  franchise  with  the  apparent 
approval  of  the  State  of  New  York,  cannot  be  totally 
disregarded  by  the  rate  making  tribunal.  We  can 
neither  accept  the  proposition  that  rates  are  to  be  based 
upon  securities  issued,  nor,  in  all  cases,  arbitrarily 
assert  that  no  consideration  whatever  shall  be  given 


to  the  bona  fide  holders  of  securities,  only  a  small  part 
of  the  proceeds  of  which  may  have  been  used  for  the 
public  benefit.  Situations  may  arise  in^which^  the 
community  is  morally  estopped  to  assert  its  full  right 
to  have  rates  based  only  upon  the  honest  and  reason- 
ably prudent  investment. 

But  what  I  am  now  arguing  for  is  not  a  rate  making 
code,  it  is  for  a  rate  making  principle.  I  would  set  a 
standard.  I  would  have  agreement  upon  the  funda- 
mental basis. 

My  proposition  is  that  the  reproduction-cost  standard 
is,  in  essence  and  in  nearly  all  its  necessary  applications, 
fallacious,  dishonest,  unstable,  impossible  of  speedy  and 
efficient  application,  and  tends  to  destroy  just  and 
harmonious  relations  between  investing  public  and 
rate  paying  public;  that,  on  the  other  hand,  the  honest- 
and  -  reasonably  -  prudent  -  investment  standard  is  in 
essence  and  in  most  of  its  applications,  sound,  honest, 
stable,  capable  of  speedy  and  efficient  application  and 
tends  to  establish  and  maintain  just  and  harmonious 
relations  between  investing  public  and  rate  paying 
public. 

If  it  is  suggested  that  the  investment  theory  logically 
involves  the  necessity  of  governmental  control  both  of 
original  and  supplementary  security  issues  by  the 
Interstate  Commerce  Commission,  I  answer  that  that 
is  far  from  being  an  adequate  reason  for  rejecting  the 
theory.  Indeed,  it  may  be  an  additional  argument  for 
the  theory.  That  is,  however,  too  large  a  subject  now 
even  to  touch  upon. 

But  the  present  condition  of  chaotic  conflict  between 
legislative  and  judicial  powers,  between  commission- 
made  rates  and  judicial  review  thereof,  is  intolerable. 
Some  relief  must  be  found.  In  Massachusetts  we  are 
now  in  this  dilemma:  If  we  enforce  our  Massachusetts 
law,  as  we  did  in  the  Middlesex  and  Boston  Rate  Case, 
we  protect  investments  made  in  the  depreciated  trolley 
properties,  a  considerable  part  of  which  under  the  re- 
production-cost theory  would  have  to  be  held  to  be 
finally  and  irretrievably  lost  to  the  stockholders. 
Naturally,  therefore,  the  unprosperous  trolley  compan- 
ies regard  the  investment  theory  as  the  bulwark  of 
their  liberties  and  sing  paeans  to  its  supporters.  But 
the  overprosperous  Gas  Companies,  with  surpluses 
derived  from  decades  of  extortionate  rates,  whenever 
a  reduction  is  suggested,  cry — "Confiscation,"  de- 
nounce us  as  thieves  and  robbers,  and  threaten  the 
regulating  commission  with  court  injunctions.  We 
must  therefore  pay  more  to  the  unprosperous  trolleys 
because  hitherto  we  have  (probably)  paid  too  little  to 
them;  and  more  to  the  overprosperous  gas  companies 
because  we  have  hitherto  paid  them  too  much.  "Com- 
ing and  going,"  the  public  pays. 

If  the  genesis  of  the  reproduction-cost  theory  is  as  I 


36 


THE      UTILITIES      MAGAZINE 


have  indicated;  if  my  thinking  is  even  approximately 
correct,  the  way  to  get  the  desired  exodus  of  this  con- 
geries of  absurd,  unjust  and  inconsistent  fallacies  is  to 
promote  legislation — national  and  state — declaring  that 
a  fair  return  shall,  under  normal  conditions,  be  reck- 
oned upon  the  capital  furnished  for  the  utility,  and 
only  upon  that. 

To  make  the  fight  only  in  the  courts  is  to  waste  our 
energies  and  to  admit  that  on  matters  purely  legislative 
we  are,  nevertheless,  a  court-governed  people. 


When  should  we  have  had  a  tolerable  system  of  deal- 
ing with  industrial  accidents  if  we  had  struggled  to 
induce  the  courts  to  overrule  the  doctrines  of  "fellow- 
servant,"  " assumption-of-risk, "  and  "due-care  on  the 
plaintiff,"  instead  of  going  to  the  legislatures  for  com- 
pensation acts.'' 

The  judge-made  rate  law  is  as  bad  as  the  judge-made 
accident  law.  Both  grew  mainly  out  of  legislative  inade- 
quacy and  not  out  of  judicial  usurpation.  Let  the  legis- 
latures now  take  up  and  finish  their  half-done  work! 


ORIGINAL  COST  AS  THE  CHIEF  BASIS  FOR  FAIR  VALUE 

By  Edward  W.  Bemis 

Member  of  Advisory  Board,  Valuation  Division,  Interstate  Commerce  Commission  and  City  Representative  on  Board  of  Supervising  Engineers,  Chicago 


A  COMPREHENSIVE  statement  of  this  big 
subject  is  out  of  the  question  in  a  short  paper, 
but  if  a  few  points  can  be  brought  out  clearly, 
the  writer's  object  will  have  been  attained. 

If  a  fair  rate  for  gas  is  sought  in  Boston  or  Baltimore, 
we  may  find  a  rate  that  will  give  a  fair  return  on  any 
investment  put  into  the  property  by  the  stockholders 
or  bondholders,  or  even  furnished,  it  may  be,  from 
surplus.  We  may  also  discover  that  early  development 
costs  have  been  paid  back  by  later  profits.  But  we 
are  suddenly  halted.  We  are  told  that,  thanks  to 
railroad  or  harbor  improvements,  which  may  even 
cheapen  the  cost  of  materials  for  the  manufacturer, 
land  in  the  neighborhood  has  risen  in  value,  and  that 
the  price  of  gas  cannot  be  reduced,  lest  6  per  cent  to 
8  per  cent  be  not  earned  on  this  unearned  increase  in 
the  value  of  land. 

A  few  sky-scrapers  go  up  between  the  Grand  Central 
and  the  Pennsylvania  stations,  in  New  York,  enhancing 
the  site  value  of  those  depots.  In  consequence,  the 
freight  and  passenger  rates  from  New  York  to  San 
Francisco  must  be  raised,  or  reductions  otherwise 
possible  must  be  denied,  in  order  that  the  New  York 
Central  and  the  Pennsylvania  may  earn  on  the  increased 
value  of  their  terminals. 

Such  is  the  outcome  of  the  reproduction  cost  in  its 
relation  to  fair  value.  If  this  theory  be  carried  out  in 
its  logical  fullness,  the  valuation  of  railroads  which  is 
now  being  made  will  so  much  exceed  their  actual  cost 
as  to  justify  increases  of  rates  that  will  startle  the 
country. 

By  original  cost  in  the  case  of  physical  assets  is  meant 
the  actual  cost  of  the  property  now  in  use.  In  repro- 
duction cost  we  attempt  to  determine  the  present  day 
cost  of  replacing  the  existing  property,  if  it  were  sud- 


denly removed  or  destroyed.  In  both  cases,  deprecia- 
tion, or  the  estimated  decline  in  units  of  service,  from 
wear,  obsolescence,  inadequacy,  or  any  other  causes, 
is  equally  to  be  considered.  Estimates  also  are  neces- 
sary, in  both  lines  of  investigation,  but  with  the  im- 
portant difference  that  reproduction  cost  is  all  an  esti- 
mate, based  on  current  prices  of  labor  and  materials, 
while  the  original  cost  is  only  partly  based  on  estimates, 
worked  out  from  a  knowledge  of  prices  of  labor  and 
materials  at  different  periods  in  the  past  when  the 
property  was  built.  In  considerable  degree — and  in 
some  cases  in  almost  its  entirety — the  actual  cost  can 
be  found  in  the  books,  vouchers,  and  other  records  of 
the  company. 

BLOWS  AT  REPRODUCTION   COST 

Both  actual  and  reproductive  cost  may  well  be  de- 
termined as  checks  upon  each  other,  and  to  justify  the 
demands  of  many  courts  and  commissions.  The  tend- 
ency, however,  to  rely  only  upon  reproduction  cost 
has  of  late  received  many  a  deserved  blow.  In  the 
first  place,  many  engineers  have  repudiated  present 
prices  on  fluctuating  commodities,  and  have  begun 
taking  five-year  averages.  The  justification  of  this 
was  not  that  we  thus  can  secure  present  day  cost, 
which  would  be  a  false  claim,  but  that  we  secure  a 
fairer  basis  for  rate  making,  and  even  for  purchase. 

Then  the  Wisconsin  Commission  and  other  commis- 
sions, and  also  the  courts,  quite  generally  have  refused 
to  include  in  reproduction  cost  the  expenses  that  would 
be  incurred  in  cutting  through  and  restoring  paving 
over  mains  and  conduits  where  such  paving  was  put 
in  by  a  city  after  the  mains  were  first  laid.  ,  This  emi- 
nently fair  treatment  of  the  case  has  proven  a  severe 
blow  to  the  reproductive  theory. 


ORIGINAL      COST 


37 


Another  blow  was  delivered  by  the  United  States 
Supreme  Court  in  the  Minnesota  Rate  Cases,  when  the 
value  of  adjoining  land  was  taken  as  the  criterion  of 
the  value  of  a  railroad  right  of  way,  without  any  addi- 
tion for  severance  damages,  plottage  values,  holdup 
charges,  cost  of  acquisition,  interest  and  taxes  during 
construction  of  the  improvements  on  land,  etc. 

Although  Mr.  Pierce  Butler  seeks  to  explain  the 
decision  as  due  to  defects  in  the  evidence  offered  by 
carriers,  equally  thorough  students  of  the  case  hold  that 
the  Court  intended  to  allow  to  the  railroad  much  less 
than  the  cost  of  reproducing  its  right  of  way  today, 
even  though  the  evidence  of  what  that  would  be  were 
convincingly  presented. 

It  seems  likely  that  the  United  States  Supreme 
Court,  while  not  yet  ready  to  accept  the  actual  cost  of 
a  property  as  the  chief  factor  in  a  rate  case,  is  never- 
theless so  worried  over  the  result  of  giving  a  road  that 
the  reproductive  theory  would  logically  call  for,  that 
it  is  using  the  present  value  of  adjoining  property — 
which  may  not  exceed  half  the  reproduction  cost,  al- 
though perhaps  on  the  average,  much  over  twice  the 
actual  cost, — as  a  compromise  measure. 

It  is  not  only  in  the  case  of  land  that  the  original  cost 
theory  is  gaining  increasing  recognition  as  a  basis  for 
fair  value,  but  in  the  case  of  all  other  physical  proper- 
ties it  is  recognized  that  most  of  our  utilities  were  built 
when  prices  of  labor  and  materials  were  lower  than  now, 
and  under  conditions  of  piecemeal  construction  which 
required  less  overhead  charges  of  all  kinds  than  now 
would  be  required  under  wholesale  reconstruction  in  a 
short  space  of  time. 

A  fourth  blow  has  been  struck  at  the  reproduction 
theory  in  the  recommendation  of  the  now  famous 
Valuation  Commission  of  the  American  Society  of  Civil 
Engineers,  that  reproduction  cost  should  be  estimated 
under  original  conditions  of  topography,  such  as  forest 
growths,  soils,  and  quantities  of  grading,  rather  than 
under  the  natural  conditions  that  would  today  con- 
front an  actual  reproduction,  if  we  could  assume  the 
utility  suddenly  blotted  out  and  the  present  day  con- 
figuration and  character  of  the  adjacent  land  to  be 
extended  over  the  site  of  the  roadbed. 

If  the  engineer  is  to  become  also  the  accountant  and 
economist,  and  to  try  to  patch  up  the  reproduction 
theory  by  considerations  foreign  to  it,  this  assumed 
restoration  of  original  topography  may  introduce  some 
elements  of  fairness,  but  it  is  no  longer  the  logical 
reproduction  theory. 

In  still  a  fifth  way  the  reproduction  theory  has  been 
hard  hit,  and  original  cost  adopted  in  its  place,  viz., 
the  determination  of  going  value  by  the  Wisconsin 
Railroad  Commission  and  by  the  New  York  State  Court 
of  Appeals.     Instead  of  basing  going  value  upon  the 


cost  of  reproducing  the  business,  as  do  Alvord,  Metcalf, 
and  others,  following  the  logic  of  the  reproduction 
method,  the  Wisconsin  and  New  York  authorities 
above  mentioned  adopt  the  purely  historical  theory  of 
early  deficits  not  made  up  by  later  profits.  Indeed, 
the  justification  of  an  allowance  for  going  value  on  the 
reproduction  method,  by  any  court  or  state  commis- 
sion outside  of  New  Jersey,  would  be  hard  to  find. 

In  its  able,  though  not  conclusive,  opinion  on  going 
value,  the  New  York  Court  of  Appeals  not  only  dis- 
cards the  reproduction  theory  in  the  direct  computa- 
tion of  going  value,  but  it  bases  its  conclusions  relative 
to  possible  early  deficits  on  the  actual  original  cost 
instead  of  on  the  reproduction  cost  of  the  physical 
property  itself.  In  this  case  (Kings  County  Lighting 
Co.  vs.  Willcox,  decided  March  24,  1914)  the  actual 
investment  or  cost  of  the  property,  less  depreciation, 
and  not  the  estimated  reproduction  cost,  was  used  as 
the  basis  on  which  earnings  were  to  be  computed  in 
determining  whether  the  company  had  obtained  such 
a  reasonable  return  as  to  have  lost  any  claim  for  going 
value.     It  is  thus  expressed  in  the  syllabus: 

"The  public  service  commission  in  fixing  the  rates  of  a 
public  service  corporation,  must  allow  the  corporation  a 
fair  return  on  its  investment,  on  the  value  of  the  property 
used  by  it  in  the  public  service,  and  in  determining  such 
value,  it  must  consider  as  a  separate  item,  apart  from  the 
physical  property,  the  'Going  value'  on  the  business,  if  any, 
which  is,  for  rate  purposes,  'the  amount  equal  to  the  defi- 
ciency of  net  earnings  below  a  fair  return  on  the  actual  in- 
vestment, due  solely  to  the  time  and  expenditures  reasonably 
necessary  and  proper  to  the  development  of  the  business  and 
property  to  its  present  stage,  and  not  comprised  in  the  val- 
uation of  the  physical  property,'  and  whether  there  is  such  a 
deficiency  or  'going  value'  is  a  question  of  fact,  the  determi- 
nation of  which  is  primarily  for  the  rate-making  body,  but 
an  advisable  method  to  determine  such  fact  is  to  consider 
the  actual  experience  of  the  company,  the  original  invest- 
ment, its  earnings  from  the  start,  the  time  actually  required 
and  expenditures  not  reflected  by  the  present  condition  of  the 
physical  property,  the  extent  to  which  bad  management  or 
other  causes  prevented  or  depleted  earnings,"  etc. 

In  other  words,  the  "actual  experience  of  the  com- 
pany or  orginal  investment"  is  the  basis  for  all  studies 
of  a  fair  return  and  for  the  determination  of  whether  the 
company  has  an  equitable  claim  against  the  public  to 
make  up  parly  losses  under  the  term  "going  value." 

ACTUAL  COST  IS  USUALLY  JUST 

Actual  cost  appeals  to  one's  sense  of  justice  and  fair 
dealing  and  leads  to  security  of  investment,  more  than 
does  the  reproduction  cost.  This  is  easily  seen  in  the 
case  of  falling  prices,  such  as  have  often  prevailed  for 
long  periods  of  time,  as,  for  example,  in  this  country 


38 


THE      UTILITIES      MAGAZINE 


prior  to  1896.  In  the  case  of  rising  prices,  the  investor's 
judgment  may  be  clouded  by  personal  gain  attaching 
to  the  acceptance  of  the  reproduction  theory.  Was  it 
not  Macaulay  who  said  that  many  would  deny  that 
two  and  two  make  four,  if  there  were  profit  in  so  doing? 

Suppose,  however,  that  prices  were  steadily  falling, 
as  prior  to  1896;  and  suppose  that  property  costing  $1,- 
000,000,  in  a  public  utility,  could  be  duplicated  later 
for  $800,000.  How  many  investors  who  now  champion 
the  reproduction  theory  of  valuation  would  adhere  to 
it  when  it  meant  a  scaling  down  of  their  original  invest- 
ment by  the  decline  in  the  price  level,  independent  of 
any  form  of  depreciation  in  the  property  itself?  The 
question  carries  its  own  answer.    . 

Let  us  note  some  evidence  of  the  growing  revolt 
against  the  dominance  of  the  reproduction  theory. 
The  papers  read  at  this  and  last  year's  conference 
should  be  first  noted : 

THE  AGENCY  THEORY 

The  recent  Secretary  of  the  Interior,  Walter  L. 
Fisher,  a  prominent  Chicago  attorney,  endorsed  the 
cost  theory  with  respect  to  railroads  when  he  accepted 
the  theory  that  the  railroads  occupy  a  trust  relation 
toward  the  people;  for  a  trustee  must  return  the  actual 
investment  committed  to  his  care  and  cannot  keep  the 
increments  that  might  come  to  him  while  in  his  charge. 
Mr.  Fisher  gives  his  views  on  this  trust  relation  in  his 
report  on  Alaskan  Coal  Problems,'  and  quotes  with 
approval  some  court  decisions  as  follows: 

"The  Supreme  Court  of  the  United  States  said  in  United 
States  vs.  Joint  Tariff  Association  (181  U.  S.,  505-570):  'The 
business  of  a  railroad  carrier  is  of  a  public  nature,  and  in 
performing  it  the  carrier  is  also  performing,  to  a  certain 
extent,  a  function  of  government.'  In  Talcott  vs.  Pine  Grove 
(23  Federal  Cases,  652),  the  United  States  Circuit  Court  for 
the  Western  Division  of  Michigan  said  that  railway  corpora- 
tions 'exercise  delegated  sovereign  rights'  and  are  'but  a 

portion  of  the  public  government And  it  is  not 

true,  we  submit,  that  it  is  in  degree  only  that  these  franchises 
differ  in  their  relations  to  the  public  from  mills  and  inns,  as 
is  said  in  People  vs.  Salem.  The  one  is  private  property;  the 
other  is  a  political  function,  which,  when  resting  in  the 
hands  of  government  where  originally  it  resided,  or  delegated 
still  for  the  same  public  use,  to  either  persons  or  corporations, 
ever  has  been,  and  of  right  may  be,  aided  by  taxation. 
.  .  .  .  It  is  for  the  performance  and  regulation  of  this 
old  and  famiUar  governmental  duty,  in  a  mode  deemed  by  the 
legislature  most  efficient  and  economical,  that  in  modern 
times  railway  and  other  corporations  have  been  created. 
And  in  the  most  plenary  and  critical  sense,  under  the  general 
railroad  law  of  Michigan,  they  are  parts  of  the  political 
organism.  The  road,  once  constructed,  is,  instanter  and 
by  mere  force  of  the  grant  and  law,  embodied  in  the 
governmental  agencies  of  the  state  and  dedicated  to  pub- 

'Department  of  the  Interior,  Bureau  of  Mines,  Bulletin  36,  1911. 


lie  use.  All  and  singular  its  cars,  engines,  rights  of  ways, 
and  property  of  every  description,  real,  personal,  and  mixed, 
are  but  a  trust  fund  for  the  political  power,  like  the  functions 
of  a  public  office.'  " 

The  agency  theory,  with  its  insistence  upon  the  su- 
preme importance  of  original  cost,  has  been  accepted 
in  its  entirety  by  Brooks  Adams,  the  well  known  Bos- 
ton authority,  in  his  brief,  in  1910,  for  the  Railroad 
Commission  of  the  State  of  Washington  on  Railways 
as  Public  Agents  (printed  by  the  Plympton  Press,[^Nor- 
wood,  Mass.). 

Mr.  H.  P.  Gillette  has  fully  accepted  the  agency,  or 
cost,  theory  with  respect  to  future  construction.  He 
has  written  {Railroad  Gazette,  January  10,  1913,  page 
56): 

"  It  seems  to  the  writer  inevitable  that  the  agency  theory 
will  eventually  be  adopted  in  its  entirety  for  appraisals  of 
public  service  property  created  in  the  future.  In  other  words, 
the  actual  cost  of  the  property  including  the  accumulated 
deficits  in  fair  return  will  be  rate  making  value.  Even  incre- 
ments in  land  value  will  be  reported  as  profits,  that  is,  as 
part  of  the  fair  return." 

His  reason  for  not  applying  this  just  rule  to  present 
value  will  not  be  convincing  to  all.     He  puts  it  thus: 

"When  a  newly  evolved  code  of  morals  made  it  reprehen- 
sible to  own  slaves,  there  were  men  who  advocated  freeing 
the  slaves  without  giving  compensation  to  the  owners.  It 
would  have  been  more  just  had  the  general  public  been  taxed 
to  purchase  freedom  for  the  slaves,  and  it  would  also  have 
been  more  economic  than  the  war  that  made  them  free." 

Perhaps  a  better  illustration  may  be  taken  from  taxa- 
tion. As  we  gradually  educate  the  public  to  more  just 
theories  of  taxation,  or  to  a  different  treatment  of  the 
saloon  question,  from  that  previously  prevailing  we 
change  our  system  of  taxation,  or  of  sumptuary  legis- 
lation, without  any  compensation  to  the  large  property 
owners  thereby  injured,  while  the  general  public  welfare 
is  increased.  The  time  probably  will  come  when  the 
long  process  of  education  as  to  the  equity  of  actual  or 
estimated  cost  will  bring  its  general  adoption  as  the 
preponderating,  although  not  usually  the  only  factor 
in  fair  value. 

ESTIMATES  OF  ORIGINAL  COST 

Mr.  Hammond  V.  Hayes,  formerly  Chief  Engineer  of 
the  American  Telephone  Company,  has  endorsed  the 
importance  and  practicability  of  ascertaining  and 
using  actual  original  cost.  On  this  point  may  be  quoted 
the  following  from  his  recent  volume  on  Public  Utilities, 
Their  Fair  Present  Value  and  Return  (page  126-8) : 

"The  age  of  each  unit  of  perishable  property  must  be  as- 
certained in  every  valuation  for  the  purpose  of  determining 
the  loss  in  value  of  the  unit  due  to  depreciation.     The  present 


ORIGINAL   COST 


39 


value  of  the  items  of  perishable  property,  whether  that  value 
is  based  on  original  cost  or  replacement  cost,  is  the  cost-new- 
less-depreciation.  The  present  value  of  the  property  as  a 
whole  is  the  value  of  the  perishable  property  in  its  present 
condition  plus  the  value  of  the  non-perishable  property. 
With  the  ages  of  all  units  known,  it  is  only  necessary  to  group 
together  units  of  the  same  kind  and  age.  The  age  indicates 
directly  the  year  in  which  the  units  were  purchased.  The 
price  paid  for  each  unit  in  each  year  in  the  past  can  be  ob- 
tained readily  from  the  books  of  the  company,  or  if  such 
records  are  not  available,  it  rarely  would  be  difScult  to  ob- 
tain reliable  figures  from  outside  sources.  The  product  of 
the  unit  cost  for  each  year,  obtained  in  this  manner,  multi- 
plied by  the  number  of  units  found  by  a  knowledge  of  their 
age  to  have  been  installed  in  that  year,  gives  the  costs  for 
each  year  of  the  perishable  property.  The  sum  of  the  costs 
of  all  units  for  all  years  gives  the  total  actual  original  cost  of 
all  perishable  property.  To  this  sum  must  be  added  the 
actual  cost  of  the  non-perishable  physical  property,     .     ,     . 

"These  unit  costs  are  actual  costs,  whereas  the  unit  costs 
used  in  a  determination  of  the  replacement  cost  are  based 
theoretically  upon  the  assumption  that  all  material  and 
labor  must  be  figured  at  the  prices  prevailing  on  a  par- 
ticular day,  and  that  such  prices  should  be  not  the  actual 
prices  but  what  they  would  be  if  the  market  were  normal. 
Original  cost,  being  actual  cost,  avoids  the  contentious 
question  usually  incident  to  replacement  cost — whether  such 
a  figure  should  show  the  cost  of  plant  replaced  in  a  wholesale 
or  in  a  piecemeal  manner.  There  are  many  other  similar 
points  favoring  the  reliability  of  a  figure  representative  of 
actual  original  cost,  derived  as  described  above,  which  are  of 
interest  to  the  expert  on  valuation  but  need  not  be  consid- 
ered here.  Every  consideration  tends  to  show  that  the  act- 
ual cost  of  an  existing  plant  is  a  more  acceptable  figure,  as 
far  as  the  accuracy  of  its  determination  is  concerned,  than  a 
figure  based  upon  the  supposititious  replacement  of  a  plant. 
All  doubt  as  to  the  reliability  of  the  books  of  the  company  is 
removed,  as  the  inventory  establishes  the  present  useful 
items  of  property  and  their  ages.  The  books  of  the  company 
can  be  trusted  to  show  what  was  paid  for  labor  and  material 
and,  even  if  this  is  doubted,  market  rates  for  labor  and 
material  for  the  years  in  question  can  be  obtained  from 
other  sources. 

"It  must  be  distinctly  understood  that  the  above  argu- 
ments in  favor  of  actual  original  cost  are  not  intended  to 
advocate  the  use  of  that  figure  to  the  exclusion  of  the  re- 
'  placement  cost.  On  the  contrary;,  figures  to  show  the  re- 
placement cost  have  been  demanded  by  the  courts  and  must 
be  prepared  and  presented  to  the  rate  making  tribunal,  for 
its  information.  The  point  it  is  wished  here  to  emphasize 
is  simply  that  the  actual  original  cost  is  likewise  a  figure  of 
importance  and  is  one  which  has  been  greatly  neglected  in 
the  past.  The  actual  original  cost  is  capable  of  determina- 
tion with  quite  as  great  a  degree  of  accuracy  as  the  replace- 
ment cost  and  can  be  accepted  in  many  cases  with  less 
controversy." 


THE  REPRODUCTION  THEORY  IN  BUFFALO 

Mr.  Frederick  P.  Stearns,  chairman  of  the  Valuation 
Committee  of  the  American  Society  of  Civil  Engineers, 
endorses  both  the  importance  of  original  cost  and  the 
practicability  of  estimating  it  where  the  records  are 
missing. 

The  recent  able  chairman  of  the  Public  Service  Com- 
mission of  New  York,  Second  District,  Mr.  Frank  W. 
Stevens,  in  his  epoch  making  decision  in  the  Buffalo 
Gas  Company  case,  February  4,  1913,  which  everyone 
connected  with  valuation  work  should  read,  exposes 
the  weaknesses  of  the  reproduction  theory  in  a  most 
startling  manner.  After  making  some  estimates  of  re- 
production cost  of  manufacturing  apparatus,  he  says : 

"These  findings  as  to  reproduction  costs  are  subject  to 
the  same  criticism  as  that  upon  the  reproduction  cost  of 
street  mains  hereinafter  discussed,  namely,  that  the  unit 
prices  are  of  such  a  character  that  no  particular  sum  within 
a  range  of  25  per  cent  can  be  called  more  than  a  guess." 

Pertaining  to  the  prices  of  cast  iron  pipe,  he  says 
that  the  prices  per  ton  in  Buffalo  have  not  only  fluc- 
tuated violently  from  year  to  year  but  that  even  the 
average  of  five-year  periods  has  also  greatly  fluctuated, 
as  shown  in  the  following  table : 

1893-97  1898-1902  1903-07  1908-12 


$20.59  $24.89  $31.48  $24.02 

This  alone  would  make  a  variation  in  the  appraisal  of 
the  price  of  pipe  as  follows: 

1893-97  1898-1902  1903-07  1908-12 


$617,700 


$746,700  $944,400  $720,600 


Two  able  engineers  produced  by  the  Buffalo  Gas 
Company  differed  52  per  cent  with  respect  to  the  cost 
of  labor  and  accessories  in  pipe  laid,  104  per  cent  in  the 
cost  of  rock  excavation  and  143  per  cent  in  the  cost  of 
interest,  engineering,  and  inspection.  A  difference 
between  these  two  engineers  in  the  cost  for  labor  and 
accessories  in  laying  mains  in  ordinary  soil  and  through 
rock  in  the  streets  of  Buffalo  would  mean  a  total  varia- 
tion of  price  of  3.15  cents  per  thousand  feet  of  gas, 
if  the  company  be  entitled  to  6  per  cent  on  the  differ- 
ence in  the  two  valuations.  Mr.  Stevens  goes  on  to 
show  how  unit  prices  differ  widely  in  different  cities 
and  in  the  experience  of  different  engineers,  and  says 
after  an  exhaustive  investigation : 

"We  have  gone  at  some  length  into  the  question  of  unit 
prices  because  of  its  tremendous  importance  in  the  valua- 
tion of  property  upon  the  theory  of  reproduction  cost. 
We  have  shown  how  with  the  enormous  quantities  involved 
in  large  properties  small  variations  in  unit  prices  will  make 
large  differences  in  aggregate  results,  which  must  affect  mater- 


40 


THE      UTILITIES      MAGAZINE 


ially  and  very  seriously  the  price  to  the  pubHc  and  the  return 
to  the  company.  The  theory  of  reproduction  cost  as  to  the 
value  of  the  property  is  not  one  to  be  depended  upon. 
However  correct  or  incorrect  in  theory  reproduction  cost  as 
representing  the  value  of  an  existing  property  may  be,  it 
obviously  can  not  be  used  so  as  to  produce  a  result  which  is 
just  and  reasonable  unless  both  the  quantities  and  unit  prices 
are  reasonably  satisfactory.  In  the  case  of  many  articles, 
unit  prices  are  easily  ascertainable.  In  the  case  of  many 
other  articles,  and  in  the  case  of  labor  costs,  as  is  shown  above, 
they  are  extremely  uncertain  and  produce  results  which  are 

so  discordant  as  to  be  amazing 

"All  of  the  engineers  whose  estimates  are  given  are  straight- 
forward, competent  men,  and  they  had  a  right  to  rely  upon 
their  experiences.  Their  experiences  have  varied,  and  what 
the  experience  would  be  in  re-laying  411  miles  of  pipe  in  the 
city  of  Buffalo  under  various  conditions  of  traffic,  soil,  and 
obstructions  under  the  surface  of  the  soil,  no  man  knows  or 
can  know  within  a  variation  of  hundreds  of  thousands  of 
dollars.  For  these  reasons,  the  Commission  is  unable  to  find 
definitely  what  the  fair  and  reasonable  reproduction  cost  of 
these  mains  would  be." 

In  a  later  case,  decided  April  2,  1913,  by  the  same 
public  service  commission  of  the  Second  District,  being 
the  case  of  the  City  of  Buffalo  vs.  The  Cataract  Power 
and  Conduit  Company,  the  matter  was  taken  up  still 
further  and  this  conclusion  was  reached: 

"Without  prolonging  the  discussion,  the  conclusion  of  the 
Commission  is  that  in  this  case  the  fair  value  of  the  prop- 
erty used  in  the  public  service,  or  what  is  equivalent  thereto, 
the  fair  amount  of  the  investment  upon  which  the  return 
should  be  computed,  may  be  better  ascertained  by  giving 
the  greater  weight  to  the  actual  cost  as  the  basis  of  the 
inquiry  than  in  any  other  way.  This  actual  cost  may  require 
diminution  if  it  should  be  found  that  the  expenditures  were 
extravagant  or  wasteful.  It  may  require  increase  if  it  be 
found  that  *any  of  the  property  has  actually  increased  in 
value  since  it  was  brought  into  the  public  service,  and  it 
may  require  increase  for  other  reasons.  It  is  not  assumed 
that  the  actual  amount  of  money  expended  by  the  company 
and  placed  upon  its  books  as  the  cost  of  the  property  is  the 
fair  value.  It  is,  however,  assumed  that  such  cost  taken  as 
the  chief  basis  of  investigation  will  lead  to  more  just  and 
equitable  results  than  any  other  one  basis  which  is  afforded 
by  the  evidence  in  the  case." 

GRAY  ON  ORIGINAL  COST 

Prof.  John  H.  Gray,  late  President  of  the  American 
Economic  Association,  in  his  address  at  its  annual  meet- 
ing in  Minneapolis  in  December,  1913  (reprinted  from 
the  proceedings  of  the  twenty-sixth  annual  meeting), 
strongly  endorses  original  cost  as  by  far  the  most  im- 
portant element  in  the  valuation  of  property  in  rate 
cases.  Referring  to  how  the  Burlington  road  claimed 
that,  although  its  property  had  cost  its  stock  and  bond 
holders  only  $258,000,000,  it  now  had  on  the  repro- 
duction theory  a  value  of  $530,000,000  due  to  an  in- 


crease of  $150,000,000  in  land  values  and  $122,000,000 
in  property  acquired  in  earnings  (Western  Advance 
Rate  Case,  20  I.  C.  C.  R.  page  332),  Professor  Gray 
comments  as  follows : 

"To  state  the  case  in  another  way,  does  anybody  suppose 
that  if  the  state  had  built  this  road  itself,  as  it  had  both  a 
moral  and  legal  right  to  do,  the  public  would  ever  have 
seriously  considered  the  raising  of  the  rates  on  this  road  to 
provide  an  income  on  value  thus  created  from  either  surplus 
earnings  or  from  the  increase  in  land  values  caused  by  social 
progress.''  Yet  this  increase  is  the  logical  outcome  of  the 
route  we  have  been  traveling.  Cannot  anyone  see  clearly 
that  to  continue  on  this  road  is  to  give  the  utilities  all  the 
chance  for  speculative  gains  that  exists  in  purely  private 
business,  at  the  same  time  that  we,  in  fact,  under  the  theory 
of  regulated  monoply  and  the  capitalizing  of  losses,  insure 
them  against  all  losses  in  case  the  venture  proves  unprofitable? 
In  short,  we  have  arrived,  from  the  standpoint  of  the  com- 
panies, at  the  happy  maxim  of  'Heads,  I  win;  tails,  you  lose.' 

"To  resume  briefly:  When  the  public  first  began  to  realize 
the  importance  of  the  utilities  to  the  public  welfare  (more 
particularly  after  the  Supreme  Court  declared  the  industries 
'affected  with  a  public  interest'  in  1876),  the  public  desire 
centered  about  the  attempt  to  prevent  the  companies  from 
earning  dividends  on  watered  stock.  In  attempts  to  carry 
out  this  public  desire,  the  courts  invented  the  theory  of  fair 
value  of  property.  This  necessitated  a  valuation  of  the 
property.  The  courts  in  this  situation  sympathizing  with 
property  rights  and  vested  interests,  and  innocent  of  economic 
learning  and  without  proper  facilities  for  making  scientific 
investigation,  and,  also,  finding  themselves  overloaded  with 
work,  permitted  the  companies  to  foist  upon  them  the  false 
theory  of  cost  of  reproducing  the  property  and  business  and 
thus  caused  the  emphasis  to  be  thrown  on  rates  rather  than 
on  capitalization. 

"While  it  is  true  that  the  courts  have  never  laid  down  a 
rule  as  to  the  part  that  cost  of  reproduction  should  play  in 
valuation,  such  theories,  as  I  have  already  shown,  occupy 
nearly  all  the  evidence  in  the  cases,  and  constitute  the  bulk 
of  all  the  arguments  of  the  attorneys  for  the  companies. 
Beyond  doubt,  they  have,  in  fact,  so  far  been  given  over- 
whelming influence  in  the  decisions.  The  only  hope  at  this 
point  is  that  the  courts,  having  never  laid  down  any  rule, 
and,  consequently,  never  having  revealed  the  working  of 
their  minds,  have  left  the  gate  wide  open  for  a  graceful  re- 
treat as  soon  as  they  wake  up  and  realize  what  their  practices 
have  led  to.  There  is  no  hope  through  regulation  till  there 
is  such  a  reversal,  in  fact,  if  not  in  form.  Unless  such  a 
change  is  speedily  brought  about,  we  are  sure  to  move  rapidly 
towards  public  ownership  and  operation, — a  condition  for 
which  our  traditions  and  form  of  government  are  at  present 
ill  adapted." 

SOME  DECISIONS  FAVORABLE  TO 
ORIGINAL  COST 

The  New  Brunswick  Board  of  Commissioners  of 
Public  Utilities  in  its  decision  of  April  22,  1914,  with 
respect  to  the  Eastern  Electric  &  Development  Com- 


ORIGINAL   COST 


41 


pany    favors    original    cost.     In    discussing    the    two 
appraisals  submitted  in  this  case,  the  Board  said : 

"Both  are  made  up  by  taking  the  present  replacement  cost 
and  deducting  certain  percentages  for  depreciation.  We 
are  by  no  means  satisfied  with  the  replacement  cost  as  a 
trustworthy  guide.  It  is  a  difficult  standard  to  apply,  even 
when  there  has  been  no  marked  difference  in  construction 
cost,  between  the  time  or  times  when  the  plant  was  installed 
and  the  time  when  the  estimate  of  replacement  cost  was  made. 

"  Before  the  advance  in  cost  of  labor  and  materials  replace- 
ment cost  was  usually  less  than  the  actual  cost  of  building 
up  a  plant,  principally  because  it  would  be  cheaper  to  install 
a  complete  equipment  under  one  contract  than  it  actually 
was  to  build  it  up  piecemeal,  and  then  it  was  common  for 
consumers  and  the  public  generally  to  insist  that  the  re- 
placement cost  was  the  only  proper  basis  for  rate  making; 
but  in  many  cases  this  would  work  manifest  injustice  to 
those  public  utility  companies  which  had  expended  their 
money  prudently  and  wisely  and  as  occasion  required  to 
meet  all  reasonable  calls  for  service,  thereby  necessarily 
expending  more  than  if  they  had  put  in  the  whole  equipment 
at  once.  We  think  that  if  that  standard  had  been  rigidly 
followed,  it  would  have  driven  public  utility  corporations  to 
erect  plants  far  in  advance  of  their  requirements,  and  to 
have  invested  large  amounts  of  capital  in  plants  which  must 
have  lain  idle,  and  would  have  deteriorated  without  being 
in  a  position  to  earn  money.  The  public  would  certainly 
have  objected  to  rates  which  would  have  enabled  a  company 
to  earn  a  reasonable  return  upon  such  premature  develop- 
ment, so  that  either  way  the  public  utility  company  would 
have  been  likely  to  suffer  an  injustice. 

"But  now  conditions  are  changed;  owing  to  the  greatly  in- 
creased construction  cost,  the  replacement  value  instead  of 
being  less  is  more  than  the  amounts  actually  expended  in 
establishing  plants  (except,  of  course,  those  built  up  very 
recently),  and  now  the  public  utility  companies  insist  that 
the  present  replacement  cost  with  a  reasonable  allowance  for 
depreciation  should  be  the  basis  upon  which  rates  should  be 
fixed  while  the  consumers  object. 

"We  have  thought  it  well  to  state  at  some  length  the 
opinion  of  the  Board  as  to  replacement  cost  as  a  standard. 
In  our  view  it  is  not  only  a  difficult  one  to  apply,  as  was  said 
above,  but  owing  to  the  fluctuations  in  cost  above  referred 
to,  it  is  not  only  a  difficult  but  an  uncertain  standard.  For 
these  reasons  we  do  not  look  upon  either  of  these  appraisals 
as  particularly  useful  in  assisting  the  Board  to  arrive  at  a 
just  conclusion  as  to  the  present  value  or  actual  cost  of 
this  plant     .     .     .     .     " 

The  New  Hampshire  Public  Service  Commission  has 
placed  the  chief  emphasis  on  original  investment  or 
cost  in  the  Berlin  Electric  Light  Company  Case  re- 
ported August  31, 1915.  It  merely  qualifies  its  endorse- 
ment by  recognizing  first,  as  do  all  believers  in  the  cost 
theory,  that  we  must  also  take  into  account  whether 
the  property  was  well  conceived  and  well  managed  and 
whether  it  has  been  reasonably  profitable. 


The  Massachusetts  Public  Service  Commission  has 
adopted  the  cost  theory  of  valuation.  In  the  Middle- 
sex and  Boston  Rate  Case,  decided  October  28,  1914, 
with  respect  to  rates  of  fare  upon  a  street  railway,  the 
Commission   held : 

"If  regulation  is  to  limit  (as  it  should)  the  profits  of  stock- 
holders to  a  moderate  return,  not  greatly  in  excess  of  an 
investment  rate,  regulation  must  also  protect,  so  far  as  it 
reasonably  may,  all  investments  honestly  and  prudently 
made  and  properly  managed  in  the  public  service;  otherwise 
there  will  be  no  such  investments.  It  is  entirely  clear  that 
in  the  long  run  the  rate  paying  public  as  well  as  the  investing 
public  will  be  best  served  if  regulation  makes  as  its  funda- 
mentally guiding  principle  an  attempt  to  protect  investments 
honestly  and  prudently  made  and  wisely  managed.  Any 
other  theory  involves  essential  injustice,  tends  to  make  the 
development  of  our  public  utility  companies  a  speculation 
and  not  an  investment,  operates  as  a  premium  upon  various 
kinds  of  fraud;  invites  into  the  public  service  undesirable 
manipulators  instead  of  sound,  level-headed  business  man- 
agers; makes  every  rate  case  an  almost  interminable  and 
labyrinthine  inquiry  into  values  with  endless  conflicts  be- 
tween so-called  experts." 

The  Public  Service  Commission  of  the  First  District 
has  in  several  decisions  recognized  the  importance  of 
securing  the  actual  cost  of  the  property;  for  example, 
in  the  Kings  County  Lighting  Case  (2  P.  S.  C.  1st  Dis- 
trict, N.  Y.,  pages  680-1)  the  Commission  states  that 
the  New  York  law  requires  the  Commission  in  deter- 
mining gas  and  electric  rates  to — 

"consider  all  facts  which  in  its  judgment  have  any  bearing 
upon  a  proper  determination  of  the  question  .... 
with  due  regard  among  other  things  to  a  reasonable  average 
return  upon  capital  actually  expended." 

The  Commission,  however,  properly  recognized  that 
depreciation  in  all  its  forms  must  be  deducted  from  the 
actual  original  cost  as  well  as  from  any  estimated  re- 
production cost,  under  the  following  clear  statement  in 
this  respect: 

"the  mere  fact  of  investment  does  not  establish  a  perpetual 
value  not  only  because  a  mistake  in  judgment  may  be  made, 
but  also  because  property  may  be  allowed  to  deteriorate, 
because  progress  in  the  arts  may  make  it  obsolete,  and  be- 
cause a  change  in  economic  conditions  may  decrease  the  use 

made  of  it  by  the  public To  assert  that  because 

a  company  at  one  time  put  money  into  property  which  has 
become  useless,  worn-out  and  obsolete,  a  successor  company 
which  purchased  that  property  at  a  foreclosure  sale  should  be 
allowed  to  capitalize  for  the  amount  originally  expended  is 
so  absurd  as  not  to  require  further  discussion.  Investment 
may  be  evidence  of  the  good  intentions  of  the  investor,  but 
it  is  not  an  infallible  standard  of  perpetual  value." 

In  this  connection  it  may  be  observed  that  railroad 
attorneys,  with  their  usual  insistence  on  technicalities. 


42 


THE      UTILITIES      MAGAZINE 


are  claiming  that  under  the  Valuation  Act  the  Inter- 
state Commerce  Commission  cannot  set  up  estimated 
depreciation  on  the  actual  cost  of  the  property,  but 
only  on  its  reproduction  cost.  This  view,  absurd  from 
the  engineer's  and  the  economist's  standpoint,  and  en- 
tirely contrary  to  the  intention  of  Senator  LaFollette 
and  others  responsible  for  the  bill,  is  based  upon  a  clause 
in  the  act  wherein  the  Commission  is  ordered  to  report 
"the  original  cost  to  date,  the  cost  of  reproduction  new, 
the  cost  of  reproduction  less  depreciation,"  without 
any  special  reference  to  depreciation  on  original  cost. 

Fortunately  the  act  further  provides  that  "in  ascer- 
taining the  original  cost  to  date  of  the  property  of  such 
common  carrier,  the  Commission,  in  addition  to  such 
other  elements  as  it  may  deem  necessary,  shall"  etc., 
thus  implying  the  right  to  use  any  elements  deemed 
necessary  for  determining  original  cost.  Again,  "The 
Commission  shall  have  power  to  prescribe  the  method 
of  procedure  to  be  followed  in  the  method  of  investiga- 
tion," thus  implying  the  use  of  any  suitable  methods. 
This  language,  it  is  believed,  will  fully  justify  the 
application  to  the  actual  cost  of  the  property  now  in 
use,  the  same  percentage  of  depreciation  that  the  engi- 
neers apply  to  the  estimated  reproduction  cost  of  the 
same  property.  But  this  matter  is  yet  to  be  deter- 
mined by  the  Commission. 

The  oldest  of  our  State  commissions — the  Massa- 
chusetts Gas  and  Electric  Light  Commission — has 
always  sought  to  base  a  fair  value  for  rates  on  capitali- 
zation, and  to  restrict  capitalization  to  that  part  only 
of  the  cost  that  has  been  borne  by  direct  contributions 
of  the  stockholders  and  bondholders.  The  propriety  of 
this  further  step,  successfully  maintained  in  the  recent 
Haverhill  Gas  Case,  is  not  now  under  discussion,  but  is 
mentioned  here  only  as  it  is  based  on  the  acceptance  of 
original  cost  as  all  important. 

It  is  natural  that  railroad  and  public  utility  attorneys 
should  adopt  the  theory  of  reproduction  cost,  which 
fully  applied,  is  their  only  way  of  securing  the  many 
enormously  valuable  unearned  increments  for  which 
they  contend.  How  far  the  believers  in  the  justice  of 
original  cost  will  be  able  to  impress  their  point  of  view 
upon  the  valuation  now  under  way  of  our  railroad. 


telegraph,  long  distance  telephone,  and  interstate  elec- 
tric railways  and  power  companies,  will  depend  to  a 
large  extent  upon  the  attitude  and  efforts  of  those  in 
attendance  at  this  Conference. 

BIG  ISSUES  AT  STAKE 

Little  does  the  country  appreciate  the  significance  of 
the  work  now  going  on  at  Washington  in  the  valuation 
of  the  railroads,  with  respect  to  this  matter  of  reproduc- 
tion cost  versus  actual  cost.  Through  ignorance  or 
through  direct  purpose  the  accounts  of  a  majority  of 
our  railroads  have  been  kept  so  that  we  cannot  deter- 
mine therefrom  the  actual  cost  of  a  large  portion  of 
their  physical  property,  to  say  nothing  of  determining 
what  was  built  by  direct  contributions  of  the  owners, 
and  what  was  built  out  of  surplus  earnings  or  in  the 
form  of  maintenance  incorrectly  charged  to  operating 
expenses. 

Unless  those  in  charge  of  the  valuation  work  shall 
see  their  way  clear  to  have  engineering  estimates  made 
of  the  reasonable  cost  of  construction  at  the  time  when 
built,  of  such  portions  of  the  property  now  in  use  as 
cannot  be  traced  to  the  actual  cost  on  the  books  and 
other  records  of  the  company,  we  shall  have  no  val- 
uation whatever  of  a  large  portion  of  the  railroads  of 
this  country,  outside  of  the  rolling  stock,  and  perhaps 
land,  rails  and  a  few  small  items  except  that  furnished 
on  the  basis  of  estimates  of  reproduction  costs  today. 
Precedents  will  also  be  established  of  ignoring  the 
actual  historical  costs,  which  will  have  far  reaching  and 
almost  overwhelming  influence  in  the  work  of  valuing 
city  utilities  and  in  the  decisions  of  our  state  railroad 
and  public  service  commissions  and  of  our  courts. 

No  time  is  to  be  lost!  We  are  now  facing  issues 
fraught  with  as  great  economic  significance,  and  giving 
promise  of  as  stirring  political  controversies,  as  have 
ever  attended  our  pubhc  discussions  of  tariffs,  money, 
or  even  the  emancipation  of  the  slaves.  The  differ- 
ence between  the  cost  of  our  public  utilities  less  their 
depreciation,  and  their  estimated  reproduction  cost 
less  depreciation,  is  much  greater  than  the  value  of  all 
slaves  freed  in  1863.  We  may  well  pause  and  consider. 
Momentous  issues  are  now  being  decided. 


ORIGINAL      COST 


43 


ORIGINAL  COST 

By  Halford  Erickson 

Chairman,  Wisconsin  Railroad  Commission 


IT  IS  with  some  hesitation  that  I  comply  with  the  re- 
quest to  furnish  a  brief  discussion  on  what  is  really 
meant  by  the  original  cost  of  public  utilities  and 
on  how  this  cost  may  be  determined.  The  main  reason 
for  this  hesitancy  may  be  traced  to  the  many  uncertain 
and  conflicting  views  concerning  it  that  appear  in 
current  discussions  upon  this  subject.  Among  the 
elements  that  should  be  given  consideration  in  determin- 
ing the  fair  value  of  the  utilities  there  is  hardly  one 
that  is  more  frequently  mentioned  or  to  which  many 
attach  greater  importance  than  is  the  case  for  original 
cost.  And  yet  this  cost  seldom  appears  to  be  either 
clearly  defined  or  fully  determined,  nor  has  it  often 
been  so  used  in  the  appraisals  that  one  can  definitely 
tell  just  what  weight  has  been  given  to  it  therein. 

Inquiries  into  the  original  cost  are  in  a  measure 
historical  in  their  nature.  They  involve  to  some  ex- 
tent the  cost  of  each  unit  of  property  from  the  time  it 
is  first  placed  in  the  service  to  the  time  it  is  taken  out 
of  the  service  or  replaced  by  some  other  unit.  These 
costs,  or  the  material  upon  which  they  are  computed, 
may  be  obtained  from  the  original  records  of  the  plant, 
as  well  as  from  other  sources.  The  following  brief 
discussion  upon  this  subject  is  largely  made  up  of  what 
I  have  already  had  occasion  to  say  regarding  it  in 
other  connections. 

Now,  what  is  meant  by  the  "original  cost  to  date"? 
Is  it  the  cost  of  the  units  of  property  first  installed  plus 
the  entire  cost  of  the  new  units  by  which  the  original 
units  may  have  been  replaced  when  worn  out  or  ren- 
dered useless;  or  is  it  the  cost  of  the  original  units  plus, 
on  the  one  hand,  only  those  amounts  by  which  the  cost 
of  the  new  units  by  which  wornout  units  were  replaced 
exceeded  the  cost  of  the  unit  taken  out,  and  minus,  on 
the  other  hand,  the  amounts  by  which  the  cost  of  the 
units  installed  for  renewal  purposes  are  lower  than  the 
costs  of  the  units  taken  out  or  replaced?  Its  meaning 
can  not  very  well  agree  with  the  first  of  these  illustra- 
tions; for  if  it  did,  it  would  follow  that  for  plants  old 
enough  to  have  had  any  considerable  parts  of  the 
property  renewed,  the  cost  of  the  same  would  be 
entirely  too  great  in  proportion  to  their  "fair  value." 
Again,  it  would  mean  that  the  cost  of  renewals  already 
borne  by  the  public  through  rates  for  service  high 
enough  to  cover  depreciation  might  also  be  included 
in  the  fair  value  upon  which  interest  and  profits  should 
be -allowed.  It  might  also  lead  to  higher  than  fair 
valuations  for  other  purposes. 

The  second  in  order  of  the  above  two  illustrations 


appears  to  much  more  fully  and  justly  cover  actual 
conditions.  The  cost  of  the  property  first  installed, 
if  in  existence,  is  of  course  a  part  of  the  cost  of  a  plant. 
The  cost  of  renewing  depreciated  and  useless  property, 
however,  should  be  viewed  in  a  different  light.  De- 
preciation, within  certain  broad  limits,  should  be  covered 
in  the  rates  charged  by  the  utility  for  service  rendered, 
and  in  most  cases  is  undoubtedly  so  covered,  whether 
set  aside  in  a  reserve  or  in  some  form  paid  out  to  the 
owner  of  the  utility.  Such  depreciation  charges  are  usu- 
ally supposed  to  cover  the  cost  of  the  unit  to  which  they 
apply.  If,  when  the  time  for  renewals  has  actually 
arrived,  it  is  found  that  through  changes  in  prices  the 
actual  cost  of  such  renewals  either  exceeds  or  falls  below 
the  cost  of  the  unit  replaced  or  the  cost  covered  by 
depreciation  charges,  then  it  is  proper  that  such  differ- 
ences between  the  cost  of  the  units  put  in  place  of  the 
unit  taken  out  should  receive  recognition  in  determining 
the  cost  to  date. 

In  order  to  recognize  in  the  cost  of  the  plant  such 
differences  between  the  cost  of  the  property  taken  out 
and  the  cost  of  the  property  by  which  it  is  replaced,  it 
is  only  necessary  to  charge  the  construction  account 
with  the  actual  cost  of  the  first  property  or  units  as 
well  as  with  the  actual  cost  of  each  unit  by  which  exist- 
ing units  are  renewed,  and  to  credit  the  construction 
account  with  the  actual  cost  of  each  unit  taken  out. 
When  the  construction  account  is  properly  charged 
and  credited  in  this  manner  the  balance  in  this  account 
at  any  particular  time  will  show  what  may  be  regarded 
as  the  proper  original  cost  to  the  investors  of  the  prop- 
erty of  the  utility.  In  order  to  illustrate  a  properly 
kept  construction  account  from  this  point  of  view  the 
following  table  is  included. 

The  following  account  or  illustration  covers  a  hy- 
pothetical plant  costing  $9,000  when  first  built,  and 
made  up  of  three  classes  of  property  of  which  the  first, 
or  class  "A,"  amounts  to  $3,000  and  has  a  life  of  three 
years;  while  the  second,  or  class  "B,"  amounting  to 
$3,000  has  a  useful  life  of  six  years  and  the  third,  or 
class  "C,"  also  costing  $3,000,  has  a  life  of  nine  years. 
For  the  sake  of  simplicity,  only  one  account  is  used. 
This  account  is  charged  with  the  first  cost  of  the  plant 
which  amounted  to  $9,000.  It  is  subsequently  charged 
with  the  cost  of  the  units  put  in  and  credited  with  the 
cost  of  each  unit  or  class  of  property  taken  out,  when 
renewals  had  to  be  made.  It  covers  such  entries  for  a 
period  of  something  more  than  twelve  years.  No  ex- 
tensions beyond  the  first  construction  are  supposed 


44 


THE      UTILITIES      MAGAZINE 


to  have  been  made,  although  such  extensions  would 
in  no  way  have  affected  the  principles  involved,  since 
extensions  must  be  treated  the  same  as  the  original 
parts  of  the  plant. 


CONSTRUCTION  ACCOUNT 


Charges 

Credits 

Total  Cost  Original  Plant 

$9,000 

Renewal 

Cost 

1st 

Class  A  3d    Year 

3,500 

Class  A  taken  out  1st  Time  $3,000 

2d 

"     A  6th     " 

3,700 

"     A     ' 

"       "     2d     "        3,500 

1st 

"     B  6th     " 

3,300 

"     A 

"      1st     "         3,000 

3d 

"     A  9th     " 

3,700 

"     B     • 

''       "     3d      "        3,700 

1st 

"     C  9th     " 

3,200 

"     C     ' 

"        "      1st     "        3,000 

2d 

"     B  12th    " 

3,700 

"     B 

"      2d      "        3,300 

4th 

"     A  12th    " 

3,600 

"     A     ' 

"        "      3d      "        3,700 

Cost  existing  property            10,500 

Total . 

.33,700 

Total.. 

33,700 

The  above  construction  account  is  thus  charged 
with  the  cost  of  the  original  plant.  This  is  the  first 
entry.  It  is  subsequently  charged  with  the  cost  of  the 
units  put  in  and  credited  with  the  cost  of  the  units 
taken  out  for  seven  different  renewals  of  the  property 
involved.  For  five  of  these  renewals  the  property  put 
in  costs  more  than  the  property  taken  out.  For  one 
of  the  renewals  the  cost  of  the  property  put  in  was  the 
same  as  the  cost  of  the  property  taken  out.  For  one 
the  cost  of  the  property  put  in  was  less  than  the  cost 
of  the  property  taken  out.  The  result  of  these  varia- 
tions in  cost  as  between  the  property  discarded  and  the 
property  put  in  its  place  is  that  the  net  cost  of  the  plant 
during  the  period  had  increased  from  $9,000  to  $10,500 
as  shown  by  the  balance  in  the  account. 

These  facts  clearly  show  that  the  cost  of  the  plant  at 
the  end  of  the  period  covered  by  the  account  amounted 
to  $10,500.  This  cost  is  also  the  amount  that  under 
normal  conditions  can  be  regarded  as  the  fair  "original 
cost  to  date"  of  the  plant.  At  any  rate,  this  is  the 
case  when  the  facts  involved  are  viewed  in  the  light 
of  economic  principles  as  well  as  when  considered  from 
the  point  of  view  of  generally  recognized  accounting 
and  operating  practices.  In  the  final  analysis  it  means 
that  the  "original  cost"  of  a  plant  is  the  cost  at  which 
the  existing  property  of  the  plant  was  acquired  and 
put  in  place.  This  conclusion  is  supported  by  the 
facts  as  well  as  in  reason. 

Had  the  construction  accounts  been  correctly  kept 
on  the  bases  just  outlined,  it  is  obvious  that  the  bal- 
ances therein  would  show  the  true  original  cost  to  date 
of  the  plants,  or  the  cost  of  their  existing  property. 
But  few,  if  any,  accounts  have  ever  been  regularly  kept 
on  this  plan.  When  the  books  and  records  are  exam- 
ined one  usually  finds  the  situation  to  be  such  that 
there  is  no  way  in  which  the  original  cost  to  date  of  the 
plant  can  be  determined  therefrom  even  with  a  fair 
degree  of  correctness.  The  first  cost  usually  includes 
many  changes  which  do  not  properly  belong  in  the 
accounts.     The  entries  also  often  bear  unmistakable 


evidence  of  both  over  and  under  charges  affecting 
otherwise  proper  items.  The  costs  of  the  property 
taken  out  and  put  in  at  the  time  of  the  renewals  of  the 
property  that  has  become  useless  through  depreciation 
are  seldom  properly  entered.  There  is  also  as  a  rule  in- 
extricable confusion  between  the  cost  of  renewals,  the 
cost  of  ordinary  repairs  or  maintenance  and  this  con- 
fusion also  extends  to  the  treatment  of  the  costs  of 
additions  and  betterments  to  the  property.  In  addi- 
tion to  complications  of  this  nature  it  is  also  a  fact 
that  for  most  utilities  the  greater  proportion  of  at  least 
the  older  records  are  out  of  existence.  The  situation 
in  these  respects  is  well  expressed  by  President  A.  T. 
Hadley  in  a  statement  printed  on  page  236  of  the  report 
of  the  Senate  Committee  on  Interstate  Commerce,  62d 
Congress,  3d  Session,  which  reads  as  follows: 

"My  own  impression,  based  partly  on  earlier  studies  and 
partly  on  experience  with  the  Commission,  is  that  it  is  going 
to  be  impossible  to  ascertain  the  original  cost  of  specific 
pieces  of  property  with  sufficient  accuracy  to  make  this  part 
of  the  work  worth  doing.  Matters  of  past  history  like  this 
are  extremely  expensive  to  follow  up.  Many  of  the  records 
were  made  at  a  time  when  railroad  bookkeeping  was  far  less 
systematized  than  it  is  now.  Some  of  them  were  made 
purposely  misleading,  not  infrequently  with  the  collusion 
of  the  State  authorities  themselves,  who  were  so  anxious  to 
have  railroads  built  that  they  encouraged  people  to  enter  the 
value  of  rights  of  way,  of  services  rendered  the  company, 
and  other  considerations  furnished  by  subscribers  to  capital 
stock  at  a  figure  purposely  in  excess  of  the  true  value.  Still 
less  possible  is  it  to  find  to  whom  money  was  paid  or  who 
sustained  the  losses  represented  by  decreased  value  of  capital 
stock  and  other  properties.  Speaking  broadly,  therefore, 
I  should  say  that  the  attempt  to  ascertain  the  cost  of  property 
in  the  past  with  any  degree  of  completeness  or  accuracy  was 
impracticable,  and  that  an  incomplete  or  inaccurate  estimate 
would  involve  an  expense  far  in  excess  of  its  utility  to  the 
public." 

When  the  cost  of  the  new  property  put  in  is  greater 
than  the  cost  of  the  depreciated  property  taken  out, 
the  excess  in  the  former  case  may  be  covered  by  the 
issuance  and  sale  of  additional  securities.  When,  on 
the  other  hand,  the  cost  of  the  property  taken  out  is 
the  greatest,  it  may  be  proper  to  charge  the  difference 
to  the  depreciation  reserve  and  credit  the  same  to  the 
surplus  account.  Such  difference  may  even  lead  to 
reductions  in  outstanding  securities.  There  are  also 
other  ways  in  which  such  differences  may  be  adjusted. 
It  may  be  noted  in  this  connection  that  the  depreciation 
reserve  being  accumulated  on  the  basis  of  the  property 
taken  out  will,  when  the  cost  of  this  property  is  the 
greatest,  necessarily  exceed  the  amount  that  is  required 
for  renewal. 

While  in  the  preceding  table  all  the  property  for  the 
sake  of  convenience  is  included  in  one  account,  it  is  not 


ORIGINAL   COST 


45 


meant  thereby  that  only  one  account  should  be  used 
for  this  purpose.  On  the  contrary,  it  is  generally  best 
in  actual  practice  to  employ  one  account  for  each  class 
of  property  or  for  each  of  the  distinct  classes  of  con- 
struction outlays.  It  is  in  dissecting  and  verifying 
these  accounts  as  ordinarily  kept,  however,  that  the 
real  difficulties  in  determining  the  original  cost  are 
encountered.  The  method  of  appraisal,  on  the  other 
hand,  which  seeks  to  derive  only  the  actual  cost  of 
existing  items  circumvents  this  difficulty,  since  the 
inventory  of  physical  items  makes  no  distinction  be- 
tween property  constructed  and  property  purchased. 
It  would,  of  course,  be  necessary  to  derive  evidence 
of  the  time  existing  units  of  property  were  first  installed, 
and  the  cost  of  such  units  at  the  time  of  their  installa- 
tion. However,  this  inquiry  would  be  directed  only 
toward  finding  cost  as  of  a  particular  date  and  would 
not  require  the  derivation  of  any  sequence  in  cost.  To 
this  end  cost  data  from  other  sources  can  be  relied 
upon  as  supporting  evidence  without  doing  violence 
to  the  theory  of  actual  cost. 

The  method  of  investment  accounting  briefly  out- 
lined above  suggests  that  carriers  are  entitled  to  charge 
the  construction  accounts  with  all  costs  necessarily 
incurred  for  capital  and  renewal  purposes  in  furnishing 
its  transportation  plant  regardless  of  the  length  of  time 
they  have  been  in  service  and,  conversely,  carriers 
should  decrease  their  construction  accounts  by  the 
amount  of  original  investment  expenditures  represented 
in  portions  of  railway  plant  retired  because  of  deprecia- 
tion, and  that  the  cost  of  depreciation  is  a  proper  charge 
to  the  operating  expenses  or  costs  upon  which  the  rates 
charged  for  the  services  rendered  are  based.  Competi- 
tive trading  recognizes  the  recoupment  of  depreciation 
loss  in  this  manner.  If  these  propositions  are  sound 
the  determination  of  the  "Actual  Cost  of  Existing 
Items"  is  equivalent  to  a  determination  of  the  correct 
accounting  balance  of  the  investment  as  of  the  present 
time. 

The  facts  and  theories  thus  presented  indicate  quite 
clearly  that  by  the  "original  cost  to  date"  of  the  so- 
called  physical  property  of  public  utilities  should 
ordinarily  be  understood  the  cost  of  the  existing  physi- 
cal property  used  for  the  convenience  of  the  public. 
These  facts  further  show  that  there  are  few,  if  any, 
instances  where  such  "original  cost  to  date"  can  be 
correctly  obtained  from  the  accounts  of  the  utility. 

The  fact,  however,  that  the  accounts  seldom  disclose 
the  true  original  cost  to  date  of  the  property  does  not 
mean  that  this  cost  cannot  be  obtained.  That  this 
is  the  case  becomes  quite  clear  when  the  conditions 


involved  are  more  fully  considered.  As  stated  above, 
the  property  involved  is  the  existing  property,  the 
very  same  property  of  which  the  cost  of  reproduction 
at  the  present  time  is  desired.  Since  the  property 
involved  is  the  same,  the  questions  involved  are  in  fact 
reduced  to  how  to  find  the  cost  of  this  property  at  the 
time  it  was  first  put  in  place,  and  how  to  find  the  present 
cost  of  reproducing  it.  The  first  step  in  obtaining 
these  costs  is  to  secure  a  complete  inventory  of  the 
property.  The  next  step  is  to  obtain  reliable  data  as 
to  the  unit  prices  of  the  labor  and  material  involved 
at  the  time  the  property  was  put  in,  as  well  as  at  the 
present  time.  With  a  complete  inventory  and  with 
full  data  as  to  unit  prices  for  the  two  periods,  the 
original  cost  new  and  the  cost  of  reproduction  new  of 
the  property  are  largely  matters  of  computation.  The 
depreciation  of  this  property  must  then  be  obtained. 
It  is  ordinarily  determined  from  facts  relating  to  the 
age,  the  expected  useful  life,  and  the  actual  condition 
of  each  part  of  the  property  involved.  The  amount  of 
the  depreciation  thus  obtained  can  then  be  applied  to 
the  original  cost  new  of  the  property  as  well  as  to  its 
cost  of  reproduction  new.  That  is,  depreciation,  being 
the  same,  can  be  applied  to  both  the  original  and  the 
present  cost  of  the  property.  When  such  depreciation 
in  both  cases  is  deducted  from  the  cost  new,  the  so- 
called  existing  value  is  obtained. 

Experience  shows  that  the  unit  prices  can  be  had 
with  fully  as  much  accuracy  for  the  period  when  the 
property  was  actually  put  in  as  for  the  period  covering 
the  present  time.  There  are,  for  instance,  few  classes 
of  labor  and  material  involved  for  which  the  records  of 
general  market  prices  does  not  extend  back  into  the 
past  for  considerable  periods.  In  addition  to  this,  the 
records  of  the  utilities  in  many  instances  will  be  found 
to  reveal  the  actual  cost  at  which  a  large  proportion 
of  the  units  or  property  were  put  in.  In  several  in- 
stances where  the  matter  was  actually  tried  out,  it  has 
been  found  that  the  original  cost  of  the  existing  property 
was  obtained  in  an  even  more  satisfactory  way  than 
the  cost  of  reproducing  it. 

While  the  views  as  to  what  is  meant  by  the  original 
cost  of  the  physical  property  that  have  thus  been  ex- 
pressed above,  differ  somewhat  from  the  more  generally 
accepted  views  upon  this  matter,  they  are  believed  to 
be  sound,  at  least  in  the  main.  To  adopt  them  with 
such  modification  as  may  be  necessary  would  not  only 
seem  correct  in  theory,  but  would  place  the  original 
cost  upon  a  basis  where  it  can  be  determined  with 
some  degree  of  correctness. 


46 


THE      UTILITIES      MAGAZINE 


CONSTITUTIONALITY  OF  HISTORICAL  COST  METHOD  OF  PUBLIC 

UTILITY  VALUATION 


By  Alfred  Bettman 

Attomey-at-Law,  Cincinnati,  Ohio 

IN  THE  regulation  of  public  utility  rates  or  the 
determination  of  the  reasonableness  of  proposed 
rates,  the  prevailing  practice  bases  such  regula- 
tion or  determination  upon  a  "valuation"  of  the  prop- 
erty of  the  utility.  Amongst  the  various  methods  of 
valuation,  two  have  the  largest  following  and  are 
contending  for  the  mastery — namely,  the  "cost  of 
reproduction"  method  and  the  "original  or  historical 
cost"  method.  Stripped  of  the  variations  and  modi- 
fications to  which  these  two  methods  are  subjected 
in  discussion  and  practice,  the  first  may  be  described 
as  the  calculation  of  the  cost  of  reproducing  the  prop- 
erty of  the  utility  in  its  existing  condition,  allowance 
being  made  for  accrued  depreciation;  while  the  "his- 
torical cost"  method  aims  to  ascertain,  from  an  analy- 
sis of  the  financial  history  of  the  utility,  the  aggregate 
amount  of  moneys  which  the  utility  has  actually  cost 
the  investors.  The  first  method  seeks  its  justification 
in  the  assumption  that  thereby  the  value  of  the 
utility  is  obtained;  whereas  proponents  of  the  second 
or  "cost"  method  claim  its  justification  in  the  theory 
that,  when  constructing  and  operating  a  public  utility, 
the  owner  thereof  acts  as  the  agent  of,  or  trustee  for, 
the  public  and  as  such  agent  or  trustee  ought  suffer 
no  financial  loss  nor  gain  any  profit,  interest  or  return 
on  the  moneys  invested  being  treated  not  as  profit 
but  as  the  cost  of  obtaining  such  moneys. 

In  the  actual  administration  of  the  cost  of  reproduc- 
tion method,  practical  considerations  and  justice  seem 
to  require  constant  departures  from  logic  and  consist- 
ency, and  the  historical  cost  theory  presents  an  increas- 
ing appeal  to  those  students  of  rate  making  who  by 
temperament  incline  toward  a  theory  which  can  be 
applied  with  relatively  strict  logic  and  consistency.' 
The  vague  and  costly  dangers  which  lurk  in  "the  cost 
of  reproducing  the  business,"  a  recent  outgrowth  of 
the  cost  of  reproduction  theory,  are  causing  more  and 
more  persons  to  seek  protection  for  the  public  interests 
in  the  adoption  of  the  historical  cost  plan.  This 
tendency  is  checked,  however,  by  the  prevalent  feeling 
that  the  courts  have  held  the  historical  cost  method 
to  be  unconstitutional,  that  is — that  rate  miking  on 
the  basis  of  historical  cost  has  been  authoritatively 
declared  to  be  unconstitutional. 

A  critical  examination  of  this  impression  is,  there- 


fore, timely.  Let  us  begin  by  posing  the  exact  ques- 
tion :  if,  by  express  statutory  language  or  by  the  author- 
ity granted  to  a  commission,  a  legislature  provides  for 
the  fixing  of  public  utUity  rates  on  the  basis  of  histori- 
cal cost,  is  such  legislation  or  the  administration 
thereof  unconstitutional  in  so  far^as  it  may  impose 
upon  any  particular  utility  lower  maximum  rates  than 
could  have  been  imposed  by  the  use  of  the  cost  of 
reproduction  method? 

The  constitutional  provisions  usually  invoked  in 
rate  cases  are  the  clauses  of  the  Fourteenth  Amend- 
ment which  provide  that  no  state  shall  "deprive  any 
person  of  life,  liberty  or  property  without  due  process 
of  law,  nor  deny  to  any  person  within  its  jurisdiction 
the  equal  protection  of  the  law,"  the  similar  due  process 
of  law  clause  of  the  Fifth  Amendment,  the  clause  of 
the  Fifth  Amendment  "nor  shall  private  property  be 
taken  for  public  use  without  just  compensation"  and 
the  analogous  provisions  of  the  state  constitutions. 
The  opinions  in  rate  cases  have  been  rather  lacking 
in  closely  reasoned  application  of  the  recognized  scope 
and  intent  of  these  clauses  to  the  facts  and  results  of 
the  particular  rate  regulation  before  the  court.  The 
three  classes  of  constitutional  prohibitions  are  fre- 
quently treated  as  though  synonymous  in  meaning  or, 
at  least,  as  though  a  rate  which  infringes  upon  any  one 
of  the  three  necessarily  thereby  violates  the  other  two. 
Any  thorough  discussion  of  the  question  must  include 
an  attempt  to  separately  apply  each  of  these  constitu- 
tional prohibitions. 

WHAT  IS  DUE  PROCESS  OF  LAW  IN 
VALUATION  PROCEEDINGS? 


^  See  address  on  "The  Regulation  of  Public  Service  Corporation"  by 
Prof.  John  H.  Gray  of  University  of  Minnesota  in  the  191S  Proceedings  of 
The  American  Economic  Association. 


First,  as  to  due  process  of  law  clause.  In  its  pri- 
mary meaning,  this  clause  simply  requires  due  proced- 
ure on  the  part  of  the  rate  making  bodies,  procedure 
which  will  give  the  utihty  involved  a  fair  opportunity 
to  present  its  side  of  the  issues.^  When,  as  is  generally 
the  case,  the  statute  under  consideration  provides  for 
due  notice  and  hearing,  opportunity  to  the  utihty 
to  produce  evidence  and  arguments  and  for  court 
review,  then  the  requirements  of  this  primary  meaning 
of  the  due  process  of  law  clause  would  seem  to  be  per- 
fectly satisfied.  The  mere  fact  that  rates  are  fixed 
upon  a  basis  of  actual  investment  rather  than  on  the 
basis  of  reproduction  cost  cannot  of  itseK  constitute 
an  absence  of  due  procedure. 

'  San  Diego  Land  Co.  vs.  National  CUy,  174  U.  S.  739. 


ORIGINAL   COST 


47 


As  developed  by  the  courts,  however,  the  due  process 
of  law  prohibition  is  directed  against  substantive 
results  as  well  as  against  unfair  procedure.  It  pro- 
hibits legislative  action  which  is  "arbitrary"  or  "capri- 
cious," which  cannot,  by  any  process  of  fair  reasoning, 
be  attributed  to  a  genuine  attempt  on  the  part  of  the 
legislature  to  find  and  formulate  some  general  principle 
reasonably  applicable  to  the  subject-matter  of  the 
legislation.  The  historical  cost  method  of  valuation 
is,  however,  based  on  a  theory  and  principle  which  may 
be  expressed  in  terms  of  economics  or  ethics  or  public 
policy,  namely,  that  the  price  to  be  paid  for  public,  as 
distinguished  from  private,  services  should  be  calcu- 
lated according  to  cost  rather  than  va^ue;  that  increase 
in  the  value  of  properties  engaged  in  public  service 
which  represents  no  increase  in  the  outlay  of  private 
capital  may  be  credited  to  the  public  and  ought,  there- 
fore, to  belong  to  the  public,  and,  in  turn,  any  decrease 
m  the  value  of  such  property  not  covered  by  repayment 
of  capital  to  the  investors  ought  to  be  borne  by  the 
public;  that  the  evils  arising  from  private  ownership 
of  public  utilities  are  largely  due  to  the  treatment  of 
such  utilities  as  speculative  enterprises  and  that  these 
evils  can  be  minimized  and  public  regulation  made 
more  effective  by  placing  investments  in  such  prop- 
erties on  a  basis  of  security  rather  than  of  risk.  One 
may  agree  or  disagree  with  these  principles ;  but  no  one 
can  affirm  that  a  legislature  might  not  genuinely  believe 
in  them  and  genuinely  seek  to  apply  them.  The  adop- 
tion by  a  legislature  of  the  "cost  "  method  of  valuation, 
therefore,  cannot  be  called  "arbitrary"  or  "capricious." 

HISTORICAL  COST  METHOD  NOT 
CONFISCATORY 

In  rate  cases  the  courts  have  further  decreed  that 
the  due  process  of  law  clause  prohibits  confiscation; 
that  is,  the  clause  is  interpreted  as  directed  not  merely 
against  unfair  procedure  and  unreasoning  or  unprin- 
cipled legislative  action,  but  also  against  legislative 
action  which  will  actually  result  in  confiscation  of 
property.  "Confiscation"  has  received  no  exact  def- 
inition. Taking  any  fair  meaning  of  the  word  "confis- 
cation" however,  the  use  in  rate  making  of  the  histori- 
cal cost  method  of  valuation  cannot  be  accused  of  being 
confiscatory.  This  method  aims  to  guard  and  secure 
every  dollar  of  private  moneys  which  has  been  honestly 
invested  in  the  production  or  performance  of  the 
public  service,  with  interest  thereon.  The  courts  have 
sometimes  held  that  the  public  is  not  necessarily  bound 
to  secure  a  return  upon  the  outlay  of  the  investors  in 
a  utility  and  that  the  fact  that  a  particular  rate  will 
not  produce  such  a  return  does  not  necessarily  demon- 
strate the  unreasonableness  or  unconstitutionality  of 
the   rate.     For    instance,    in    Covington    &    Lexington 


Turnpike  Company  vs.  Sandford,  164  U.  S.  578,  the 
court  said: — 

"A  corporation  is  not  entitled  as  of  right  and  without 
reference  to  the  interests  of  the  public,  to  realize  a  given  per 
cent  upon  its  capital  stock.  Stockholders  are  not  the  only 
persons  whose  rights  or  interests  are  to  be  considered.  The 
rights  of  the  public  are  not  to  be  ignored.  The  public  can- 
not properly  be  subjected  to  unreasonable  rates  in  order 
simply  that  stockholders  may  earn  dividends."' 

The  historical  cost  theory  of  valuation  therefore 
affords  more  protection  to  the  investment  than  the 
courts  have  declared  to  be  the  minimum  which  must 
be  furnished  in  all  cases.  To  hold  that  a  rate  based 
on  "cost"  necessarily  violates  the  due  process  of  law 
clause  because  not  based  on  "value,"  is  to  beg  the 
question;  the  very  question  before  us  being — what 
principle  of  valuation  is  imposed  or  forbidden  by  the 
due  process  of  law  clause.  The  mere  fact  that  legis- 
lation may  impair  property  values  or  lessen  earning 
capacity  does  not  demonstrate  the  unconstitutionality 
of  such  legislation.  2  Many  valid  exercises  of  the  police 
power  have  that  effect.  The  property  of  a  public 
utility  is  acquired  and  its  value  created  subject  to 
the  legislative  power  over  rates.  The  preservation 
of  that  value  cannot  be  the  sole  test  of  the  scope  of 
that  legislative  power.  Certainly  a  principle  which 
insists  on  the  protection  of  the  actual  outlay  of  capital 
and  permits  only  the  excess  of  earning  capacity  above 
a  fair  rate  of  interest  on  that  outlay  to  be  converted 
by  the  public  into  lower  rates,  cannot  justly  be  called 
confiscatory;  and  when  that  principle  is  administered 
with  the  formality  and  justice  of  procedure  which 
constitutes  the  primary  meaning  of  due  process  of  law, 
there  is  no  justification  for  holding  the  due  process  of 
law  clause  to  be  violated. 

EQUAL  PROTECTION  OF  THE  LAWS 

To  proceed  to  the  equal  protection  of  the  laws  clause. 
The  adjudged  cases  show  little  attempt  to  thoroughly 
reason  out  the  effect  of  this  clause  upon  the  rate  making 
powers.  There  appear  throughout  the  cases,  however, 
intimations  of  the  court's  thought,  and  it  is  these  inti- 
mations which  must  be  scrutinized. 

For  instance,  in  some  of  the  cases  there  lurks  the 
thought,  that  by  the  use'  of  the  cost  of  reproduction 
method  the  value  of  a  public  utility's  assets  is  ascer- 
tained, and  if  a  fair  return  is  not  allowed  upon  this  value, 
discrimination  results  against  the  public  utility,  in 
that  the  state  does  not  attempt  to  interfere  with  a  fair 

'  See  also  Reagan  vs.  Farmers'  Loan  &  Trust  Co.,  154  U.  S.  362  at  41i8. 
'  Marchant  vs.  Penn.  R.  R.,  153  U.  S.  380; 

Mugler  vs.  Kansas,  123  U.  S.  623; 

L'Hote  vs.  New  Orleans,  177  U.  S.  587; 

Freund  Police  Power  §  513. 


48 


THE      UTILITIES      MAGAZINE 


return  upon  the  value  of  property  engaged  in  private 
business.'  But  the  power  of  rate  regulation  has  been 
exercised  exclusively  over  property  affected  with  a 
public  interest.  To  regulate  the  rates  of  public  util- 
ities and  to  leave  the  earnings  of  private  businesses 
unregulated  is  a  discrimination  recognized  for  centuries 
and  arising  out  of  the  basic  distinction  between  the 
status  of  the  two  classes  of  enterprises.  Nor  is  it  true 
that  the  Constitution  prohibits  interference  with  a  fair 
return  upon  the  actual  value  of  property  employed  in 
private  business.  Many  valid  exercises  of  the  police 
power  impair  the  value  or  earning  capacity  of  prop- 
erty engaged  in  private  business.  If,  therefore,  no  un- 
reasonable discrimination  is  attempted  between  the 
different  utilities  themselves,  the  adoption  of  any  par- 
ticular method  or  basis  of  public  utility  rate  regulation 
is  not,  in  and  of  itself,  unconstitutional  discrimination. 
There  also  occurs  in  the  adjudged  cases,  vaguely 
hinted  at  rather  than  clearly  expressed,  the  thought 
that  the  equal  protection  of  the  laws  clause  requires 
an  identical  measure  of  damage  to  be  applied  in  the 
calculation  of  the  amount  to  be  paid  for  both  private 
and  quasi-public  property  taken  for  public  use,  that  fair 
value,  regardless  of  cost,  is  the  measure  of  such  damage 
applied  to  the  taking  of  private  property,  and  that, 
when  the  value  of  a  utility  exceeds  its  cost,  a  rate 
based  on  cost  is  tantamount  to  the  taking  of  its  prop- 
erty at  less  than  value  and,  therefore,  results  in  uncon- 
stitutional discrimination.^  This  thought,  however, 
that  the  equal  protection  of  the  laws  clause  imposes 
impartiality  in  the  measure  of  damages  to  be  allowed 
in  condemnation  cases,  represents  a  misleading  con- 
fusion of  two  separate  constitutional  prohibitions, 
each  of  which  has  a  sphere  of  its  own  and  is  quite  capa- 
ble of  taking  care  of  its  own  sphere.  The  eminent 
domain  clause  of  the  Constitution,  state  or  national, 
requires  just  compensation  in  every  case  of  taking 
property  for  public  use  and  itself  prevents  unjust  dis- 
crimination in  the  calculation  of  damages  to  be  paid.' 

CONSTITUTION  DOES  NOT  REQUIRE  IDENTI- 
CAL MEASURE  OF  VALUE  FOR  PRIVATE 
AND  QUASI  PUBLIC  PROPERTY 

Applying,  however,  the  equal  protection  of  the  laws 
clause  to  the  determination  of  the  measure  of  value 
of  property  taken  for  public  use,  still  an  absolutely 
identical  measure  of  value  of  all  classes  of  property, 
public,  quasi-public  or  private  would  not  be  required 
by  it.  For  this  clause  prohibits  only  arbitrary  and 
unreasonable  classification  and  permits  rational,  logi- 

'  Chicago  Elect.  Ry.  Co.  vs.  Minnesota,  134  U.  S.  418.  458. 
'  Reagan  vs.  Farmers'  Loan  &  Trust  Co.,  154  TJ.  S.  362,  399,  410. 
'  For  discussion  of  distinctions  between  eminent   domain   and  police 
powers,  see  Freund  Police  Power  §511;  Mugler  vs.  Kansas,  123  U.  S.  623. 


cal,  appropriate  classification.^  This  clause,  in  and  of 
itself,  would  permit  special  methods  of  appraising 
public  utilities  appropriate  to  such  property,  just  as 
it  permits  specially  appropriate  methods  of  assessing 
such  property  for  taxation. 

If  the  Constitution  were  interpreted  as  imposing  the 
same  method  or  measure  of  value  in  rate  cases  as  in  cases 
of  condemnation  of  private  property,  then  the  cost  of 
reproduction  method,  which  is  the  prevailing  method 
and  frequently  approved  by  the  Supreme  Court  of  the 
United  States,  would  itself  be  unconstitutional.  For 
the  measure  of  value  sanctioned  in  cases  of  condem- 
nation of  private  property  is  market  value,  a  measure 
quite  different  from  reproduction  cost  and  one  which 
will  almost  always  produce  a  result  above  or  below 
the  cost  of  reproduction.  In  a  recent  case,^  a  city, 
was  about  to  take  for  public  use  a  piece  of  land  with  the 
house  built  thereon,  a  very  ornate  and  expensive  resi- 
dence building.  At  the  time  of  the  erection  of  the 
house,  the  neighborhood  had  been  the  fashionable 
residence  district  of  the  city,  but  had  since  become  a 
tenement  house  district  of  the  poorer  sort.  The  prop- 
erty owfier  claimed  the  right  to  introduce  evidence  of 
the  cost  (both  original  and  reproduction  cost)  of 
erecting  the  house.  He  desired  to  prove  its  present 
value  by  adopting  the  very  cost  of  reproduction  method 
generally  applied  to  utility  valuations.  Obviously 
much  of  the  labor  and  materials  which  had  gone  into 
the  erection  of  the  house  had  ceased  to  have  a  value 
in  the  market  and  a  reproduction  of  this  labor  and 
materials  could  not  restore  this  value.  So  the  court 
rightly  refused  to  permit  the  introduction  of  evidence 
of  reproductive  cost  on  the  ground  that  it  had  no 
bearing  on  the  market  value  of  the  property  and  that 
market  value  of  the  house  and  lot  together  alone  deter- 
mine the  basis  of  compensation.  In  truth,  there  is 
fallacy  in  assuming  that  the  "cost  of  reproduction" 
method  discloses  value,  in  the  ordinary  sense  of  ex- 
change or  market  value.  The  market  value  of  a  stretch 
of  street  railway  track,  for  instance,  is  the  value  of  the 
rails  as  rails  or  metal,  and  not  at  all  the  cost  of  repro- 
ducing such  tracks  on  the  street.  Similarly  the  power 
house,  considered  as  a  bu'lding,  will  practically  never 
have  a  market  value  equal  to  its  reproductive  cost 
(allowing  deduction  for  depreciation),  and  the  same  is 
true  of  the  whole  utility  plant,  considered  as  a  group 
of  physical  structures  and  appliances.  Considered  as 
a  going  concern,  including  its  business  and  franchises, 
the  market  value  of  a  public  utility  is  a  standard  of 
value  absolutely  inapplicable  to  rate  regulation.  For 
the  market  value  of  a  public  utility  is  largely  or  partly 
based  upon  its  past  earning  capacity  and  on  the  chance 

*  Jeffrey  Mfg.  Co.  vs.  Blagg,  35  Supreme  St.  Rep.  167. 
»  Devon  vs.  City  of  Cincinnati,  162  Fed.  R.  683. 


ORIGINAL   COST 


49 


that  the  public  will  permit  this  earning  capacity  to 
remain  unimpaired;  whereas  rate  regulation  arises  from 
the  right  of  the  public  to  produce  change  in  the  earning 
capacity.  The  principles  of  valuation  authoritatively 
laid  down  for  the  ascertainment  of  value  in  cases  of 
condemnation  of  private  property  cannot,  in  the  nature 
of  things,  be  appropriately  applied  or  imposed  as  a 
basis  for  rate  regulation. 

JUST  COMPENSATION  FOR  PROPERTY  TAKEN 

FOR  PUBLIC  USE.     DETERMINATION  OF 

METHOD  OF  VALUATION  IN  RATE 

CASES  A  LEGISLATIVE    AND 

NOT  JUDICIAL  FUNCTION 

We  come  now  to  the  constitutional  clauses  which 
require  just  compensation  to  be  paid  for  property 
taken  for  public  use.  Reference  to  these  clauses 
appears,  on  analysis,  to  be  irrelevant  or,  at  least,  un- 
necessary in  rate  cases.  The  power  to  regulate  rates 
is  and  has  always  been  a  legislative  power  distinct  from 
the  power  to  take  property  for  public  use;  each  has  its 
own  scope  and  limitations,  and  this  drawing  of  the  con- 
stitutional limitations  upon  the  exercise  of  the  one 
into  cases  relating  to  the  other  represents  an  unnec- 
essary confusion  of  ideas. 

This  confusion  can  be  demonstrated  from  another 
angle.  The  power  of  rate  regulation  is  a  legislative 
power  and,  therefore,  the  incidental  power  of  deciding 
the  methods  of  valuation  upon  which  rates  are  to  be 
based  must  be  a  legislative  power;  whereas  the  power 
to  determine  the  measure  of  compensation  for  property 
taken  for  public  use  is  a  judicial  and  not  a  legislative 
power.i  If  the  Constitution  be  interpreted  as  permit- 
ting the  courts  to  impose  any  particular  method  or 
standard  of  rate  making  in  each  case,  then  the  Consti- 
tution has  transferred  the  power  of  rate  regulation 
from  the  legislative  to  the  judicial  branch  of  the  gov- 
ernment. But  the  Supreme  Court  of  the  United 
States  has  consistently  declared  and  continues  to  de- 
clare that  rate  regulation  is  a  legislative  power;  as,  for 
instance,  in  the  following  passage  from  the  Minnesota 
Rate  Cases,  230  U.  S.  352,  433. 

"The  rate-making  power  is  a  legislative  power  and  neces- 
sarily implies  a  range  of  legislative  discretion.  We  do  not 
sit  as  a  board  of  revision  to  substitute  our  judgment  for  that 
of  the  legislature,  or  of  the  commission  lawfully  constituted 
by  it,  as  to  matters  within  the  province  of  either.  San 
Diego  Land  &  Town  Co.  vs.  Jasper,  189  U.  S.  439,  446. — ^The 
inquiry  is  whether  the  State  has  overstepped  the  consti- 
tutional limit  by  making  the  rates  so  unreasonably  low  that 

'  Monongahela  Navigation  Co.  vs.  U.  S.,  148  U.  S.  312,  827. 


the  carriers  are  deprived  of  their  property  without  due 
process  of  law  and  denied  the  equal  protection  of  the  laws. "  ^ 

It  is,  therefore,  the  province  of  the  state  or  nation's 
legislative  organs  to  determine  the  valuation  or  other 
basis  used  to  measure  the  reasonableness  of  rates  and, 
in  passing  upon  the  constitutionality  of  the  rate,  a 
court  does  not  act  as  an  appellate  valuation  tribunal 
and  has  not  the  function  of  setting  aside  the  rate 
because  of  disagreement  with  the  theory  of  the  method 
of  valuation  used.  The  Court's  province  should  be 
the  same  as  in  passing  upon  the  constitutionality  of 
any  exercise  of  general  legislative  power — to  decide 
whether  the  legislature  has  acted  capriciously,  arbitra- 
rily, irrationally  or  upon  a  confiscatory  principle.  In 
short,  if  the  eminent  domain  clause  applies  to  rate 
regulation,  it  is  simply  the  due  process  of  law  clause  in 
another  garb.' 

THE    COURT    DECISIONS    HAVE    LEFT   THE 
QUESTION  OPEN 

We  see  then,  that,  as  a  matter  of  a  priori  reasoning, 
rate  regulation  upon  the  basis  of  historical  cost  does 
not  violate  the  provisions  of  the  Constitution  custom- 
arily cited  in  rate  cases.  The  impression  distinctly 
prevails,  however,  that  the  Supreme  Court  of  the  United 
States  has  held  that  the  cost  of  reproduction  theory 
must  be  adopted,  or,  at  least,  that  any  method  based 
on  the  ascertainment  of  actual  cost  would  be  uncon- 
stitutional in  any  case  in  which  actual  cost  is  less  than 
reproduction  cost.  It  is  true  that  the  Supreme  Court 
of  the  United  States,  as  well  as  other  courts,  has  con- 
stantly stated  a  "fair  return  upon  a  fair  value"  to  be 
the  only  lawful  basis  of  regulation,  and  has  sanctioned 
the  cost  of  reproduction  method  as  a  method  for  ascer- 
tainment of  fair  value.  But  the  reports  do  not  disclose 
any  case  in  which  the  court  necessarily  had  before  it 
this  question  of  deciding  upon  the  constitutionality 
of  a  rate  based  on  cost  as  distinguished  from  value. 
To  bring  about  this  necessity  would  require  a  case  in 
which  a  proposed  rate  would  furnish  a  proper  return 
upon  original  or  actual  cost  but  would  fall  short  of 
furnishing  a  fair  return  upon  value.  There  are  cases 
in  which  the  figures  for  both  actual  and  reproduction 
cost  (the  latter  called  value)  were  before  the  court  and 
the  court  chose  to  base  its  decision  upon  "value" 
rather  than  cost.  But  in  each  of  these  the  result  of 
the  case  would  have  been  the  same  if  the  cost  theory 
had  been  applied.  For  instance,  in  The  Minnesota 
Rate  Cases,  230  U.  S.  352,  as  to  two  of  the  railroads 

'  In  Prentia  vs.  Atlantic  Coast  Line,  211  U.  S.  210,  the  Court  through  Mr. 
Justice  Holmes,  analyzes  the  nature  of  the  act  of  rate  making,  and  concludes 
it  to  be  legislative  in  its  nature,  whether  committed  to  a  legislature,  com- 
mission or  court. 

« See  L.  &  N.  R.  R.  Co.  vs.  GarreU,  231  U.  S.  299.  313. 


50 


THE      UTILITIES      MAGAZINE 


the  Court,  passing  on  the  question  of  valuation,  found 
the  evidence  introduced  insufficient  to  enable  the 
Court  to  determine  the  value  of  the  properties  and 
therefore  insufficient  to  demonstrate  the  confiscatory 
effect  of  the  rates;  and,  as  to  the  third  railroad  involved, 
the  rates  were  confiscatory  [upon  either  "cost"  or 
"value"  basis  of  valuation.  In  Cotting  vs.  Kansas 
City  Stockyards  Co.,  183  U.  S.  79,  the  majority  of  the 
coiu-t  found  the  rates  to  be  confiscatory  upon  any 
theory  of  valuation  and  avoided  determination  of  the 
proper  basis  of  valuation.  An  analysis  of  other  leading 
cases  will  disclose  this  same  condition.'  And  few,  if 
any,  of  the  cases  involved  a  determination  of  the  con- 
stitutionality of  an  express  legislative  policy,  embodied 
in  statute  or  practice,  to  adopt  a  "cost"  theory. 
There  have  been  cases  in  which  actual  cost  exceeded 
reproductive  cost  or  value  and  in  which,  therefore, 
the  utilities  themselves  desired  the  actual  cost  basis  to 
be  used,  but  in  which  the  state  insisted  upon  the 
"value"  basis  and  was  upheld  by  the  courts.^  But 
there  is  no  case  in  which  the  issue  compelled  the  court 
to  decide  and,  therefore,  in  which  the  court  did  decide 
that  the  state  or  nation  may  not  adopt  the  cost  theory. 
In  fact  the  Supreme  Court,  evidently  realizing  the 
developing  and  fluid  condition  of  the  legal  and  consti- 
tutional principles  involved,  has  expressly  refrained 
from  deciding  that  any  particular  theory  or  theories 
must  in  all  cases  be  adopted.  Where  the  record  before 
it  disclosed  evidence  of  cost,  the  Supreme  Court  has 
generally  treated  that  evidence  as  having  some  bearing 
on  the  case  and  as  entitled  to  consideration  and  not 
as  rendered  irrelevant  by  the  Constitution.' 

The  opinions  contain  frequent  insistence  upon  the 
private  nature  of  the  property  of  public  utilities,  but 
there  occur  also,  from  time  to  time,  passages  recogniz- 
ing the  "agency"  conception  of  public  utilities;  as  for 
instance,  in  Smythe  vs.  Ames,  169  U.  S.  466,  544,  where 
the  Court  said: — 

....  A  railroad  is  a  public  highway,  and  none 
the  less  so  because  constructed  and  maintained  through  the 
agency  of  a  corporation  deriving  its  existence  and  powers 
from  the  state.  Such  a  corporation  was  created  for  public 
purposes.     It  performs  a  function  of  the  state. " 

and  in  Cotting  vs.  Kansas  City  Stock  Yards  Co.,  183 
U.  S.  79,  93,  where  some  members  of  the  court,  making 
a  distinction  between  public  utilities  proper  and  those 
enterprises  which,  like  stockyards,  are  simply  private 

'  Smythe  vs.  Ames,  169  U.  S.  466;  Cedar  Rapids  Gas  Co.  vs.  Cedar  Rapids, 
223  U.  S.  655. 

*  San  Diego  Land  Co.  vs.  National  City,  174  U.  S.  739;  Stanislaus  County 
vs.  Son  Joaquin  Co.,  192  U.  S.  201;  San  Diego  Land  Co.  vs.  Jasper,  189  U.  S. 
439. 

»  Reagan  vs.  Farmers  Loan  Co.,  154  U.  S.  362,  412;  Smyth  vs.  Ames,  169 
U.  S.  466,  546;  Son  Diego  Land  Co.  vs.  Jasper,  189  U.  S.  439;  Ames  vs. 
Union  Pacific  Co.,  64  Fed.  R.  166;  CoUing  vs.  Kansas  City,  183  U.  S.  79,  91. 


properties  affected  with  a  public  interest,  and  speaking 
of  the  investor  in  a  public  utility  proper,  said: — 

"it  may  be  said  that  he  voluntarily  accepts  all  the  condi- 
tions of  the  public  service  which  attach  to  like  service  per- 
formed by  the  State  itself. "' 

We  may  conclude,  therefore,  that  the  constitution- 
ality of  the  historical  cost  method  of  public  utility 
valuation  for  rate  making  purposes  is  still  an  open 
question. 

FUNDAMENTAL     DISTINCTION      BETWEEN 
THE  STATUTORY  APPELLATE  JURISDIC- 
TION  OF    COURTS    IN    RATE   AND 
VALUATION  CASES  AND  THEIR 
PROVINCE  IN  QUESTIONS  OF 
CONSTITUTIONALITY 

In  the  Minnesota  rate  cases  the  Supreme  Court 
declined,  in  the  valuation  of  railroad  right-of-way, 
to  adhere  to  the  logic  of  the  cost  of  reproduction 
method.  In  valuing  street-paving  over  gas-mains  and 
the  like,  where  the  existing  paving  had  been  laid  after 
the  installation  of  the  mains,  courts  have  often  justified 
the  use  of  actual  cost.  In  many  valuations  purporting 
to  be  made  on  the  basis  of  reproductive  cost,  allowance 
has  been  made  for  so-called  "going  value,"  calculated 
according  to  the  actual  losses  suffered  by  a  utility 
previous  to  the  period  when  it  began  to  pay;  obviously 
another  illogical  insertion  of  actual  cost  methods. 
This  oscillation  between  or  compounding  of  differing 
valuation  theories  seems  appropriate  to  the  process 
of  valuation,  but  out  of  place  in  a  determination  of  the 
constitutionality  of  a  particular  theory  or  compound 
of  theories  which  may  have  been  adopted  by  the 
proper  legislative  authority.  On  the  question  of  the 
value  of  any  particular  utility  not  merely  two  opinions, 
but  innumerable  variations  and  gradations  of  opinion 
are  generally  possible.  In  deciding  the  value  of  a 
utility  a  given  record  of  the  facts  and  evidence  produced 
in  a  valuation  proceeding,  the  nine  judges  of  the  Superior 
Court  of  the  United  States  might  genuinely  arrive  at 
nine  different  and  distinct  amounts.  When  the  court 
is  engaged  in  passing  upon  the  constitutionality  of  the 

•  See  also  San  Diego  Water  Co.  vs.  Son  Diego,  118  Cal.  556,  where  the  Court 
ably  discusses  various  theories  of  valuation,  demonstrates  the  inapplicability 
of  market  value,  argues  the  unfairness  of  reproductive  cost  method,  and 
practically  adopts  the  "historical  cost"  and  "agency"  theories.  The  fol- 
lowing passage  from  South  etc.  Ry.  Co.  vs.  Railroad  Commission,  210  Fed. 
R.  465,  480,  shows  a  hint  of  recognition  of  principle  that  the  disposition  of 
increase  of  value  not  due  to  added  capital  investment  is  a  question  of  legis- 
lative policy  and  not  of  constitutionality: 

"The  distribution  of  the  increment  due  to  the  increased  population  in 
the  tributary  territory  and  to  increased  density  of  traffic  is,  as  between  the 
carrier  and  its  patrons,  a  matter  of  legislative  policy,  not  to  be  controlled 
by  the  courts,  unless  less  is  left  to  the  carrier  than  a  fair  return  for  the  service 
rendered  and  the  property  employed  at  the  time  the  court  is  called  upon  to 
act." 


ORIGINAL      COST 


51 


methods  used  by  the  valuing  body,  does  not  this 
possibility  of  many  varying  results  show  that  the 
determination  of  the  value  of  the  utility  is  outside  the 
field  of  constitutional  law?  In  many  of  the  states, 
the  highest  courts  have  a  statutory  appellate  or  review- 
ing power  over  a  rate  or  valuation  fixed  by  a  public 
utilities  commission.  The  functions  of  the  courts  in 
cases  of  judicial  review  of  the  orders  of  the  Interstate 
Commerce  Commission  are  described  as  follows  in 
Interstate  Commerce  Commission  vs.  Union  Pacific  R.  R.'^ 

"It  has  been  settled  that  the  orders  of  the  Commission 
are  final  unless  (1)  beyond  the  power  which  it  could  consti- 
tutionally exercise;  or  (2)  beyond  its  statutory  power;  or 
(3)  based  upon  a  mistake  of  law.  But  questions  of  fact 
may  be  involved  in  the  determination  of  questions  of  law, 
so  that  an  order,  regular  on  its  face,  may  be  set  aside  if  it 
appears  that  (4)  the  rate  is  so  low  as  to  be  confiscatory  and 
in  violation  of  the  constitutional  prohibition  against  taking 
property  without  due  process  of  law;  or  (5)  if  the  Commission 
acted  so  arbitrarily  and  unjustly  as  to  fix  rates  contrary 
to  evidence,  or  without  evidence  to  support  it;  or  (6)  if 
the  authority  therein  involved  has  been  exercised  in  such  an 
unreasonable  manner  as  to  cause  it  to  be  within  the  ele- 
mentary rule  that  the  substance,  and  not  the  shadow, 
determines  the  validity  of  the  exercise  of  the  power." 

(2)  involves  mere  statutory  construction.  (3),  (5) 
and  (6)  involve  questions  analogous  to  those  arising  in 
error  or  appellate  proceedings  brought  to  set  aside 
the  decision  of  a  lower  tribunal  on  the  ground  that  it 

'  222  U.  S.  541.      See  also  Interstate  Commerce  Comm.  vs.  LouiaviUe  & 
N.  R.  R.  Co.,  227  U.  S.  88. 


is  contrary  to  the  evidence  or  without  support  of 
sufficient  evidence;  while  only  (1)  and  (4)  involve 
constitutional  law.  Surely  the  issues  and  point  of 
view  appropriate  to  the  determination  of  these  con- 
stitutional questions  differ  basically,  in  kind  and  not 
merely  in  degree,  from  the  issues  and  point  of  view 
appropriate  to  the  exercise  of  this  merely  appellate 
and  error  jurisdiction.  As  long  as  rate  regulation  is 
admitted  to  be  a  legislative  function  the  question 
before  the  Court,  when  the  constitutionality  of  a  rate 
based  on  a  valuation  is  attacked,  is  not  what  is  the 
correct  valuation,  but  whether  the  particular  theory 
or  method  of  valuation  used  by  the  rate  regulating 
body  can  be  called  so  capricious,  so  arbitrary,  so  lacking 
in  reasoned  principle  or  so  necessarily  confiscatory  as 
to  unquestionably  violate  the  prohibitions  of  the  Fifth 
and  Fourteenth  Amendments.  The  practice  of  regu- 
lation by  valuation  tends  to  increase.  There  is  the 
prospect  of  increasing  litigation,  with  increasing  com- 
plexities and  variations  in  the  facts  bearing  on  the 
valuations  of  the  utilities  involved.  In  cases  upon 
the  constitutionality  of  particular  exercises  of  the 
legislative  power  of  rate  regulation,  the  courts  would 
simplify  their  problem  and  avoid  much  vagueness  of 
principle  and  inconsistency,  by  maintaining  the  same 
attitude  and  remaining  within  the  same  province  as 
they  have  so  often  declared  to  be  their  proper  attitude 
and  province  when  deciding  the  constitutionality  of 
laws  passed  in  exercise  of  other  classes  of  legislative 
power. 


ACTUAL  COST 
By  Dr.  Robert  H.  Written 

Secretary,  Board  of  Estimate  and  Apportionment,  Committee  of  City  Plan,  New  York  City 


I  will  touch  briefly  on  one  or  two  phases  of  this  broad  and 
complex  problem  from  the  point  of  view  of  theory  rather 
than  of  existing  law — from  the  point  of  view  of  what  ought 
to  be  rather  than  of  what  is.  The  law  of  the  subject  is  yet 
largely  undetermined.  It  is  in  a  formative  stage  and  serious 
discussions  such  as  we  are  having  at  this  conference  will 
have  great  weight  in  its  final  settlement.  I  have  every  con- 
fidence for  the  future  that  the  "ought"  will  become  the  "is." 

For  the  normally  successful  public  utility  enterprise  the 
reasonable  rate  of  charge  is  the  rate  that  affords  the  com- 
pany a  reasonable  and  no  more  than  reasonable  compensa- 
tion for  its  entire  service  to  the  public.  Reasonable  com- 
pensation is  here  equivalent  to  the  normal  cost  of  production. 

There  is  no  reason  why  in  the  case  of  public  utility  the 
public  should  be  required  to  pay  more  than  the  normal  cost 
of  production,  and  sound  reason  why  in  the  long  run  the 
public  cannot  pay  less.     Normal  cost  of  production  is  the 


amoxmt  which  in  the  long  run  it  is  necessary  to  pay  to  secure 
the  utilities  demanded  by  the  public.  It  is  the  amount  that 
will  secure  an  equilibrium  between  demand  and  supply. 

In  the  case  of  a  commodity  requiring  no  capital  outlay  the 
normal  cost  of  production  is  easily  determined.  It  is  the 
present  normal  cost  of  the  labor  and  materials  entering  into 
its  production.  Cost  consists  merely  of  "operating  ex- 
penses" and  is  not  complicated  by  the  question  of  capital 
cost  and  interest  and  profits  thereon. 

In  the  case,  however,  of  a  commodity  requiring  a  large 
fixed  investment,  the  determination  of  a  normal  cost  of 
production  is  a  complex  process,  in  the  working  out  of  which 
there  is  room  for  a  wide  divergence  of  opinion.  To  the 
normal  cost  of  labor  and  materials  there  must  be  added  a  fair 
estimate  for  depreciation  and  a  fair  return  on  capital  cost. 
The  normal  cost  of  labor  and  materials  is  complicated  by  the 
necessity  of  including  provision  for  maintenance,  repairs  and 


52 


THE      UTILITIES      MAGAZINE 


depreciation.  The  determination  of  a  normal  return  on  a 
normal  capital  cost  requires  a  determination  of  two  very 
difficult  and  complicated  problems:  (1)  What  is  the  amount 
of  the  normal  capital  cost,  and  (2)  what  constitutes  a  normal 
return  on  such  amount. 

Normal  capital  cost  as  applied  to  a  new  enterprise  is  a 
comparatively  simple  concept;  but  what  is  it  as  applied  to  a 
long  established  enterprise — to  a  water  supply  plant,  a  gas 
plant  or  a  railroad  system?  Is  it  normal  cost  at  the  time 
originally  installed  or  last  renewed,  or,  on  the  other  hand,  is 
it  the  present  cost  of  reproduction?  Is  it  actual  cost  or 
reproduction  cost?  We  start  with  the  premise  that  the 
reasonable  rate  of  charge  is  to  be  determined  by  the  fair 
cost  of  production.  The  point  at  issue  between  actual  cost 
and  reproduction  cost  is  really  whether  by  cost  of  production 
we  mean  cost  at  a  particular  moment  or  cost  averaged  over 
a  period  of  years. 

As  justifying  the  present-moment-cost  or  reproduction 
method  it  may  be  argued  that  the  public  is  always  entitled 
to  secure  service  under  present  conditions  as  to  cost  of  pro- 
duction. It  is  entitled  to  secure  service  at  a  rate  of  charge 
sufficient  only  to  cover  cost  of  operation,  interest  and  profits 
of  a  substitute  plant  of  the  most  modern  approved  design, 
capable  of  performing  the  same  service  as  the  existing  plant. 
The  company  assumes  the  risk  and  enjoys  the  profit,  if  any, 
incident  to  this  arrangement.  This  method  involves  a  re- 
production of  the  service  rather  than  a  reproduction  of  the 
plant.  If  the  old  plant  were  wiped  out  what  would  it  cost 
at  present  to  construct  and  operate  a  plant  capable  of  per- 
forming the  service  now  performed  by  the  old  plant?  In 
the  case  of  a  water  plant,  perhaps  an  entirely  new  source  of 
supply  would  be  used  and  the  distribution  system  radically 
changed;  in  the  case  of  a  gas  plant,  a  different  process  of 
production  employed  and  a  few  large  gas  holders  substituted 
for  many  small  ones;  in  the  case  of  an  electric  plant,  larger 
units  of  production  employed;  in  the  case  of  a  railroad,  there 
might  be  a  radical  relocation  and  realignment  of  roadbed  and 
important  changes  in  the  method  of  construction,  leading  to 
great  economies  in  operating  cost.  It  has  been  stated  that 
"if  our  railways  were  to  be  built  anew,  in  the  light  of  our 
present  knowledge  and  with  our  present  traffic  offerings  and 
financial  resources,  vast  changes  would  be  made  in  the 
character  of  construction.^ 

As  thus  stated,  the  reproduction  method  has  so  many 
difficulties  that  it  is  practically  never  employed.  The 
reproduction  of  the  service  involves  not  only  the  determina- 
tion of  the  cost  of  the  most  efficient  substitute  plant,  but  the 
determination  of  the  present  cost  of  reproducing  the  business, 
the  proper  allowance  under  present  conditions  for  interest 
and  profit  and  the  operating  costs  for  the  substitute  plant. 
In  most  cases  it  is  exceedingly  difficult  and  expensive  to 
determine  the  design  of  an  equally  efficient  substitute  plant. 
In  the  case  of  a  railroad,  for  example,  the  cost  of  determining 
a  substitute  location  and  of  estimating  the  operating  costs 
thereon  would  be  so  great  as  to  render  it  entirely  impractical 
as  a  factor  in  rate  regulation.     It  would  require  a  careful 

'J.  E.  Willoughby  in  Proceedinga  of  American  Society  of  Civil  Engineers, 
January,  1911,  p.  110. 


survey  of  various  available  locations  and  estimates  of  con- 
struction and  operating  costs.  The  engineering  costs  of 
such  survey  and  estimates  would  be  enormous. 

The  cost  of  reproduction  in  practice,  therefore,  instead  of 
meaning  the  cost  of  a  substitute  plant  of  the  most  modern 
approved  design,  capable  of  performing  the  same  service  as 
the  existing  plant,  has  come  to  mean  the  cost  of  a  substantially 
identical  reproduction  of  the  existing  plant.  This  is  the 
usual  method.  It  involves,  however,  a  partial  abandonment 
of  the  reproduction  of  the  service  theory  and  a  somewhat 
imperfect  recognition  of  the  fact  that  cost  of  production  is 
necessarily  related  to  the  past  as  well  as  to  the  present  and 
future.  It  constitutes  an  imperfect  recognition  of  the  neces- 
sary continuity  in  the  life  of  the  plant  and  its  service. 

The  fallacy  in  the  reproduction  method  is  due  to  a  failure 
to  realize  the  effect  on  cost  determination  of  a  fixed  invest- 
ment of  capital.  If  a  public  service  could  be  supplied  with- 
out a  fixed  investment  it  would  be  true  that  cost  of  production 
could  be  determined  without  reference  to  the  past.  But 
these  utilities  cannot  be  supplied  without  a  large  capital 
outlay  that  cannot  be  withdrawn  at  will  and  upon  which 
a  certain  risk  has  been  assumed  in  anticipation  of  an  as- 
sumed probable  return.  As  the  utiUty  can  be  suppHed  only 
in  this  way  the  actual  cost  of  production  cannot  be  deter- 
mined without  reference  to  these  actual  conditions.  Cost 
of  production  determined  by  the  reproduction  method  is 
largely  hypothetical.  It  is  not  based  on  the  actual  condi- 
tions that  limit  the  production  of  the  utility. 

Take  the  railroad  industry.  Some  billions  of  dollars 
have  been  permanently  devoted  to  this  great  public  serv- 
ice. This  capital  cannot  be  withdrawn.  The  railroad  is 
a  fitxture.  It  has  created  and  molded  the  entire  industrial 
and  social  development;  the  location  of  industries,  popula- 
tion, cities,  has  for  the  most  part  been  controlled  by  this 
factor.  It  is  utterly  impossible  to  conceive  of  our  present 
social  and  industrial  organization  without  the  railroad. 
The  reproduction  cost  theory  as  applied  to  such  an  institu- 
tion is  particularly  fanciful.  How  can  real  cost  of  trans- 
portation be  held  to  change  from  year  to  year  with  the 
changing  reproduction  cost  of  the  railroad  right  of  way  and 
terminals?  If  railroads  were  in  fact  entirely  reconstructed 
each  year  there  would  be  reason  in  this  method  of  cost  deter- 
mination. But  they  are  not  and  cannot  be  constructed  and 
operated  on  any  such  theory.  The  real  cost  of  transporta- 
tion can  only  be  determined  by  recognizing  the  only  process 
by  which  transportation  service  can  be  supplied,  that  is  by 
devoting  capital  permanently  to  the  enterprise. 

The  reproduction  method  does  not  fit  in  with  depreciation 
and  accounting  methods.  The  annual  allowance  for  depre- 
ciation under  approved  accounting  methods  is  not  the 
amount  required  to  replace  the  existing  unit,  but  the  amount 
required  to  write  off  the  cost  of  the  existing  unit  when  it  is 
necessary  to  replace  it.  Under  approved  methods  the  actual 
cost  of  a  car  when  replaced  is  deducted  from  the  capital 
account,  and  the  cost  of  the  new  car  is  added  to  the  capital 
account.  An  allowance  for  depreciation  estimated  on  re- 
production cost  is  consequently  inaccurate  in  proportion  as 
the  reproduction  cost  differs  from  the  actual  cost.    As  long 


ORIGINAL   COST 


53 


as  the  science  of  accounts  is  predicated  on  actual  cost  it  is 
inconsistent  and  confusing  in  any  proceeding  to  determine  cost 
of  production,  to  base  either  the  accrued  depreciation  or  the 
annual  allowance  for  depreciation,  on  reproduction  rather 
than  actual  cost. 

The  determination  of  a  normal  capital  cost  is  one  step  in 
the  process  of  determining  a  normal  price,  and  this  normal 
price  is  the  amount  which  in  the  long  run  it  is  necessary  to 
pay  to  secure  the  utilities  demanded  by  the  public.  It  is 
the  amount  which  constitutes  an  adequate  inducement  for 
investment.  Starting  with  the  necessary  investment  as  a 
base  the  investor  will  estimate  all  the  risks  and  hazards  of  the 
business  of  every  kind  and  nature,  and  against  this  will  place 
all  the  possible  chances  of  profit.  The  possible  rate  of 
return  adequate  to  induce  investment  is  naturally  and 
necessarily  a  percentage  on  the  actual  cost.  From  the  stand- 
point of  the  investor,  a  rate  of  profit  based  on  any  amount 
that  is  less  than  the  actual  cost  is  in  excess  of  the  actual  rate 
of  profit,  and  a  rate  of  profit  based  on  any  amount  that  is 
greater  than  the  actual  cost  is  less  than  the  actual  rate  of 
profit. 

Assume,  for  example,  that  a  possible  annual  return  of  7 
per  cent  on  the  actual  outlay  is  reasonable  and  necessary  to 
secure  the  establishment  of  a  given  public  utility.  If,  how- 
ever, the  annual  return  is  to  be  based  not  on  actual  outlay  but 
on  estimated  reproduction  cost  in  each  year,  7  per  cent  will 
be  more  or  less  than  a  reasonable  return  in  proportion  as  the 
chances  favor  an  increase  or  a  decrease  in  reproduction  cost. 
If  costs  of  land,  labor  and  materials  are  advancing  and  all 
indications  point  to  a  continuance  of  such  increase,  a  return 
of  7  per  cent  on  such  increasing  cost  is  more  than  is  reasonable 
and  necessary  to  secure  the  establishment  of  the  given 
enterprise.  If,  on  the  other  hand,  all  indications  point  to 
a  continuous  fall  in  the  cost  of  land,  labor  and  materials,  the 
prospect  of  a  return  of  7  per  cent  on  such  decreasing  cost 
would  not  be  adequate  to  secure  the  establishment  of  the 
enterprise.  To  furnish  an  adequate  inducement,  either  the 
probable  rate  of  return  would  have  to  be  increased  or  the 
cost  of  reproduction  standard  of  determining  capital  cost 
would  have  to  be  abandoned. 

The  fair  rate  of  return  could  be  altered  so  as  in  a  measure 
to  offset  the  appreciation  or  depreciation  of  the  base  to 
which  such  rate  of  return  is  applied.  With  declining  prices 
the  risk  of  depreciation  in  reproduction  cost  would  be  offset 
by  an  increase  in  rate  of  return  and  with  advancing  prices  the 
probability  of  appreciation  would  be  offset  by  a  decrease  in 


the  rate  of  return.  This,  however,  is  but  a  poor  method  of 
accomplishing  what  can  be  more  fairly  and  logically  effected 
by  directly  basing  the  rate  of  return  on  actual  capital  cost. 
Any  method  that  is  permanently  fair  to  both  parties  must 
get  back  to  actual  capital  cost  as  the  base  for  actual  as 
distinct  from  nominal  profits. 

It  is  a  fair  assumption  that,  in  general,  investors  in  estab- 
lishing public  utilities  have  looked  to  a  fair  return  on  their 
actual  investment  to  compensate  them  for  their  outlay,  and 
have  not  taken  seriously  into  account  any  appreciation  or 
depreciation  in  the  value  of  land  or  in  the  price  of  labor  and 
materials  entering  into  the  reproduction  cost  of  structures 
and  equipment.  They  have  necessarily  assumed  that  they 
would  be  able  and  would  be  permitted  to  receive  for  their 
service  an  amount  equal  to  their  actual  cost  of  production, 
i.e.,  operating  expenses,  depreciation  and  interest  and  profits 
on  their  actual  capital  outlay. 

The  public  utility  renders  a  continuous  service  and  in 
doing  so  requires  a  permanent  fixed  capital.  Both  the  plant 
and  the  business  are  a  gradual  growth.  This  essential  con- 
tinuity of  growth  and  service  is  the  fact  that  seems  to  be 
lost  sight  of  in  present  moment  reproduction  methods  of 
determining  cost  of  production.  The  service  and  its  present 
cost  are  the  result  of  a  complex  interplay  of  factors  starting 
with  the  initiation  of  the  enterprise.  Such  cost  is  as  much 
the  result  of  past  life  and  growth  as  it  is  of  present  conditions. 
Investment,  depreciation,  operating  costs,  risk,  are  all  bound 
up  in  the  past  growth  and  development  of  the  existing 
utility. 

The  normal  actual  capital  cost  as  a  basis  for  rate  determina- 
tion moreover  has  a  distinct  advantage  from  the  stand- 
point of  public  policy.  It  is  desirable  that  rate  schedules 
should  have  stability  and  should  not  fluctuate  with  the 
price  of  iron  pipe  or  copper  wire  or  with  real  estate  activity 
or  reactions.  A  utility  is  not  established  for  the  purpose  of 
speculating  in  copper  wire  or  iron  pipe  or  land.  It  must, 
however,  in  furnishing  its  service  invest  its  money  perma- 
nently in  these  things.  The  utility  should  not  be  expected 
to  assume  the  risks  of  fluctuations  in  the  price  of  the  land  and 
materials  it  uses.  The  public  interest  is  best  subserved  and 
the  cost  of  production  is  lowered  by  reducing  the  risks  inci- 
dent to  public  utility  enterprises.  The  tendency  of  modern 
public  service  regulation  is  to  establish  more  definite  and 
equitable  relations  between  the  public  and  the  company. 
These  more  definite  relations  mean  decreased  risk  and  de- 
creased risk  means  decreased  cost  of  production. 


54 


THE      UTILITIES      MAGAZINE 


FAIR  VALUE  IN  PRACTICE 

By  Edward  P.  Bubch 

Consjdting  Engineer,  Detroit,  Mick. 


In  a  discussion  of  fair  value  the  engineer  has  always  taken 
second  place,  one  behind  the  economist.  This  status  will 
probably  continue,  because  the  basis  should  precede  the 
presentation  of  facts.  The  economist  and  the  attorney  and 
the  courts  have  not  to  this  time  furnished  an  accepted  basis 
for  valuation  work.  But  in  the  meanwhile  the  engineer  is 
called  upon  for  the  facts  and  aU  the  facts  on  the  estimated 
cost  of  property. 

The  estimated  cost  obtained  by  different  engineers  who 
appraise  the  same  property,  sometimes  varies  10  to  50  per 
cent,  or  more,  simply  because  widely  different  bases  are 
used.  The  matter  is  heralded,  and  the  engineers'  results 
may  be  discredited. 

The  engineer's  attitude,  however,  is  normally  without 
bias.  He  is  required  to  obtain  and  present  scientific  facts. 
Inventories,  prices  and  depreciation  are  to  be  set  forth  for 
each  item  of  a  property.  This  work  requires  a  judicial  atti- 
tude and  the  finding  of  facts  on  what  appears  to  be  an  equita- 
ble and  consistent  basis. 

It  is  a  matter  of  common  knowledge,  however,  that  econo- 
mists are  not  agreed  on  the  application  of  their  own  theories 
to  valuation  work;  also  that  attorneys  are  usually  biased, 
one-sided  advocates. 

It  is  not  possible  at  present  for  engineers  to  work  directly 
for  the  courts.  But  it  is  possible  for  the  engineer  to  present 
scientific  and  intelligent  facts,  and  all  the  facts,  without 
being  dictated  to  by  outside  influences.  He  can  present  an 
unbiased  attitude  and  establish  an  ethical  basis.  Usually 
that  basis  considers  the  real  sacrifice  of  the  intelligent 
investor. 

The  practical  application  of  this  basis  for  valuation  work 
must  be  made  the  study  of  the  engineer.  When  appraisal 
totals  differ,  the  reason  is  not  in  bias,  but  in  basis.  To  out- 
line three  simple  cases: 

1 .  The  company,  it  was  found,  did  not  cut  out  the  paving 
over  its  watermains  and  conduits,  because  there  was  no 
paving  when  they  were  laid.  Yet  under  present  reproduction 
conditions,  the  paving  would  have  to  be  removed  before 
similar  mains  or  conduits  could  now  be  laid.  But  the  mere 
assumption  of  reproduction  conditions  gives  no  basis  for 
values  from  an  ethical  standpoint. 

2.  The  company,  it  was  found  in  another  case,  did  lay  the 
paving  now  found  between  the  track  rails.  The  records 
show  the  fact.  Then,  under  the  engineer's  basis,  the  fact 
that  the  company  paid  for  the  paving  is  sufficient  to  warrant 
the  inclusion  of  the  track  paving  in  the  inventory. 

3.  The  company,  in  a  common  case,  laid  its  own  tracks, 


with  its  own  men  and  tools,  under  the  direction  of  its  own 
engineers.  The  addition  of  a  10  per  cent  profit  for  a  hypo- 
thetical contractor  who  did  not  furnish  men,  tools,  or  super- 
vision, is  then  mere  fancy  and  an  injustice. 

The  real  sacrifice  of  the  investor  makes  a  rather  certain 
basis  and  it  is  the  engineer's  duty  to  forget  the  lawyer's 
contention  and  find  out  whether  the  company  did  or  did  not 
make  the  investment  or  sacrifice. 

Objection  has  been  made  to  any  plan  which  allows  the 
engineer  to  decide  these  valuation  questions.  Is  that  a  fair 
proposition? 

The  engineer  with  his  staff  of  subordinates  expends  months 
obtaining  first-hand,  complete  and  systemized  information 
for  the  inventory,  for  the  unit  prices,  and  on  the  extent  of  the 
depreciation.  How  much  time  or  thought  does  the  econo- 
mist or  attorney  spend  on  the  same  proposition? 

The  engineer  not  only  reads  the  court  decisions,  but 
studies  them,  trying  to  apply  them  to  his  purchase,  con- 
demnation, or  rate  case.  To  every  hour  spent  by  en- 
gineers on  the  valuation  records  of  cost  of  reproduction 
less  depreciation,  the  attorney  or  the  economist  spends 
minutes  or  seconds.  Yet  the  attorney  in  a  valuation  case, 
fortified  with  parts  of  20  decisions  for,  and  19  or  21  de- 
cisions against  a  contention,  may  easily  forget  the  applica- 
tion of  ethics,  equity  and  actual  sacrifice. 

The  engineer  desires  a  final  ruling  on  the  long  pending 
discussion  on  whether  original  cost  less  depreciation,  or  cost 
of  reproduction  less  depreciation  is  to  serve  as  the  amount 
on  which  rates  shall  be  based. 

Original  cost,  however,  can  seldom  be  known,  and  can  be 
estimated  only  by  secondary  estimates  based  on  the  cost  of 
reproduction.  This  is  because  of  bad  or  incomplete  records 
of  accountants.  The  reproduction  basis  in  the  hands  of 
experienced  and  fair  appraisers  usually  results  in  an  amount 
which  is  higher  than  that  shown  by  original  cost. 

The  basis  for  valuations  is  not  fully  settled,  but  conscien- 
tious effort  can  be  made  to  base  estimated  cost  on  items 
which  represent  the  real  sacrifice  of  the  investor.  System- 
ized knowledge  can  take  the  place  of  guess-work.  The 
engineer  can  make  an  inventory  which  is  accurate  and 
definite;  complete  as  to  general  charges  yet  free  from  hazy 
assumptions;  the  items  in  the  inventory  can  be  multipUed  by 
normal  unit  prices;  and  the  products  can  be  depreciated 
fairly  for  wear,  decay,  obsolescence  and  inadequacy.  The 
sum  or  amount  then  found  represents,  as  accurately  and 
definitely  as  the  state  of  the  art  permits,  the  principle  factor 
on  which  rates  may  be  based. 


ORIGINAL   COST 


55 


OPEN  DISCUSSION 


Prof.  John  H.  Gray,  University  of  Minnesota,  Minne- 
apolis, Minn.: 

I  would  like  to  ask  Mr.  Anderson  a  question.  Mr.  Ander- 
son suggests  that  no  case  has  gone  up  from  Massachusetts 
to  the  Supreme  Court  of  the  United  States;  that  on  the 
method  of  valuation  Massachusetts  has  taken  the  original 
cost  for  many  years;  and  he  predicts  that  if  a  case  ever 
gets  to  the  United  States  Supreme  Court,  the  Massachu- 
setts position  will  be  upheld.  I  want  to  ask  if  he  thinks 
such  prediction  can  be  reconciled  with  the  doctrine  of  the 
Massachusetts  court  as  laid  down  in  the  Fall  River  Case,  Fall 
River  Gas  Worlcs  Co.  vs.  Board  of  Gas  and  Electric  Light  Com- 
missioners, 214  Mass.  529,  May  23,  1914? 

Mb.  Anderson: 

It  is  a  long  while  since  I  read  the  Fall  River  Gas  Case; 
but  it  does  not  occur  to  me  that  the  principle  there  enun- 
ciated has  any  bearing  on  my  main  contention  that  the 
legislature — national  or  state — -may  constitutionally  deter- 
mine the  basis  upon  which  aggregate  result  of  rates  shall 
be  determined.  The  Fall  River  Gas  Case  turned  entirely 
upon  the  construction  of  our  statutes:  The  Gas  Commission 
refused  to  approve  an  issue  of  stock  to  pay  debts  because 
the  company  had  accumulated  out  of  earnings  in  excess 
of  its  regular  dividends  of  10  per  cent  or  12  per  cent  a 
sufficient  sum  to  pay  for  the  improvements  for  which  the 
debt  was  incurred,  if  a  special  dividend  had  not  been  declared. 
On  the  record  before  the  court  it  was  held  that  this  ruling  was 
as  a  matter  of  law  wrong.  I  have  two  comments  to  make  on 
that  decision: 

(1)  I  think  on  the  record  before  the  full  court  that  the 
decision  was  wrong;  that  the  reasoning  does  not  satisfy. 

(2)  But  if  the  decision  was  not  wrong  on  the  record,  on 
another  record  which  might  properly  have  been  made,  I  am 
confident  that  our  court  would  have  come  to  the  reverse 
conclusion. 

That  case,  like  very  many  decisions  of  the  Supreme  Court 
of  the  United  States,  has  been  much  misunderstood.  It  has 
very  little  bearing  upon  the  general  question  of  the  right  of 
the  American  people,  through  their  national  and  state 
legislatures,  to  determine  the  fundamental  policy  which 
shall  control  the  relations  between  rate  payers  and  investors. 
There  is  nothing  in  that  opinion,  be  it  right  or  wrong,  which 
indicates  that  the  legislature  might  not  have  constitutionally 
done  what  the  Gas  Commission  held  they  had  done. 

I  therefore  answer  Professor  Gray's  question  by  saying 
that  the  Supreme  Court  of  the  United  States  will  never  be 
called  upon  to  reflect  the  principle  of  the  Fall  River  Gas  Case. 

Mr.  F.  W.  Stevens,  General  Valuation  Counsel,  New  York 
Central  Lines,  New  York  City: 

I  have  been  impressed  by  the  fact  that  the  cost  of  repro- 
duction seems  to  have  very  few  friends  here,  among  the 
speakers.    And  it  would  seem,  from  the  two  papers  read. 


that  I  have  taken  a  shy  at  it,  myself,  in  the  past.  I  have 
nothing  to  retract  or  withdraw  from  any  attacks  I  have 
made  upon  it,  because  I  believe  that  they  were  properly 
made;  but  I  have  been  further  impressed  with  the  preva- 
lence of  the  idea  that  it  is  unethical  and  that  apparently  it 
was  conceived  in  sin  and  bom  in  iniquity  to  perpetuate 
outrages  upon  the  public. 

We  hear  at  the  present  time  considerable  about  the  his- 
torical method.  Will  some  gentleman  please  tell  me  when, 
where  and  how  it  was  first  brought  into  these  controversies? 
Does  anybody  know  anything  about  who  brought  it  there? 
I  have  spent  many  weary  hours  and  labored  assiduously  for 
a  great  many  years,  to,  find  out  something  about  that.  I 
cannot  say  that  what  I  am  about  to  detail  was  the  first 
introduction  of  this  element  into  rate  making  controversies; 
but  it  is  the  first  I  ever  heard  of,  or  have  known  of.  It  was 
first  introduced  in  rate  making  controversies  by  the  repre- 
sentative of  a  sovereign  state  of  the  Union,  and  upon  purely 
ethical  grounds.  If  you  will  consult  Smytlie  vs.  Ames,  you 
will  learn  that  the  Supreme  Court  of  the  United  States  de- 
clared that  the  State  of  Nebraska  had  taken  an  action  in  its 
legislature  which  was  distinctly  unethical,  to  wit:  it  had  taken 
action  which  would  confiscate  the  property  of  the  railroads  of 
that  state.  I  know  nothing  about  it  only  what  the  court  said. 
In  an  effort  which  was  made  by  the  railroads  to  set  aside 
this  act  of  the  legislature,  the  late  Secretary  of  State  of  the 
United  States,  whose  conduct,  as  we  all  know,  and  whose 
disposition  are  always  based  upon  the  purest  ethical  prin- 
ciples appeared  for  the  State  of  Nebraska;  and  he  contended 
there,  upon  the  strength  of  those  principles,  that  if  the 
legislature  allowed  any  return,  no  matter  how  small,  to  the 
investors  in  the  railroad,  not  upon  the  cost,  not  upon  the 
investment,  it  was  but  a  matter  of  state  policy  with  which 
the  court  had  nothing  to  do;  but  he  said,  "If  this  is  not  the 
law,  then  I  say  to  you  that  the  return  which  should  be 
allowed,  should  be  upon  the  cost  of  reproduction";  and  that 
was  the  contention  made  by  the  State  of  Nebraska;  and  what 
are  the  ethics  of  it?  If  you  will  refer  to  his  argument,  you 
will  find  it  was  put  upon  a  purely  ethical  ground,  as  I  said 
before;  and  that  was,  that  the  railroads  had  cost  something 
over  $30,000  a  mile  but  they  could  be  reproduced  at  that 
time  for  $20,000  a  mile. 

One  more  remark.  I  find  myself  placed  in  a  very  embar- 
rassing position  here,  and  I  doubt  whether  what  I  am  about 
to  say  I  should  say,  or  not;  but  in  the  moment's  reflection 
that  I  have  given  to  it,  I  feel  compelled  to  say  this:  in  the 
paper  of  Professor  Bemis,  I  find  myself  quoted,  in  connection 
with  another  gentleman,  as  in  favor  of  the  cost  basis  for  the 
rate  making  function.  I  wish  to  say  that  if  the  gentleman 
had  done  me  the  honor  to  read  all  of  the  decisions  which 
I  have  made,  that  he  would  have  discovered  that — while  I 
now  stand  for  every  word  which  I  said  in  the  Buffalo  case 
and  the  Cataract  case  and  the  General-Electric  case, — that 
I  am  not  now  and  never  have  been  in  favor  of  the  principle 


56 


THE      UTILITIES      MAGAZINE 


which  he  advocates:  that  rates  should  at  all  times  and  all 
places  be  based  upon  cost. 

My  personal  opinions  are  of  no  consequence;  but,  having 
been  quoted  in  that  connection,  I  wish  to  say  distinctly  that 
I  do  not  believe  that  it  is  workable,  that  it  is  possible,  or 
that  it  is  just,  in  large  numbers  of  cases:  in  some  cases  it  is 
absolutely  right.  This  is  a  personal  explanation,  made  to 
avoid  any  misapprehension  whatsoever  as  to  my  position. 

Mr.  F.  p.  Stearns,  Consulting  Engineer,  Boston,  Mass.: 

The  discussion  this  morning  has  to  do  with  the  actual  cost 
basis  in  valuation,  but  has  extended  to  a  discussion  of  the 
relative  merits  of  actual  cost  and  reproduction  cost. 

I  am  heartily  in  accord  with  the  view  that  actual  cost 
rather  than  reproduction  cost  ought  to  be  the  basis  for  the 
future,  with  proper  legislation  and  under  commission  control. 
Under  such  circumstances  results  which  are  fair  to  the 
owner  of  the  property  and  to  the  public  can  be  attained. 

In  dealing  with  old  properties,  large  parts  of  which  were 
built  many  years  ago,  it  is  frequently  not  possible  to  obtain 
the  actual  cost,  and  it  may  also  be  inequitable  to  use  it  if  it 
could  be  obtained.  Equities  may  have  developed  in  the 
meantime  which  may  make  the  use  of  the  actual  cost  basis 
unfair.  For  instance,  I  have  known  the  case  of  an  old 
utility  where  the  rates  gave  an  inadequate  return  upon  the 
investment  in  the  property,  and  the  only  way  in  which 
the  company  received  a  fair  return  was  through  the  apprecia- 
tion of  its  large  investment  in  land.  The  appreciation  of 
the  land,  plus  the  amount  received  for  rates,  gave  it  a  fair 
return.  To  value  the  property  at  the  present  time  at  the 
original  cost  of  the  land  would  give  unfair  results. 

Coming  to  the  subject  which  I  wish  especially  to  discuss, 
namely,  the  proper  conception  of  reproduction  cost,  I  note 
that  everyone  who  has  referred  to  the  subject  has  spoken 
of  reproduction  cost  as  if  it  were  necessarily  the  cost  of 
reproducing  a  property  under  the  conditions  existing  at 
the  present  time.  I  recognize  that  this  is  the  prevaiHng 
view  and  that  it  conforms  with  the  definition  given  by  the 
courts,  but  it  seems  to  me  to  be  an  incorrect  view  and  one 
which  is  responsible  for  many  of  the  irrational  features  of 
the  reproduction  theory. 

A  more  rational  conception  of  reproduction  cost  is  the 
reproduction  of  the  property  as  it  was  produced;  that  is, 
under  the  physical  conditions  originally  existing. 

Mr.  Knowles,  in  speaking  last  night,  commented  favorably 
upon  the  view  of  the  Wisconsin  -Commission  that  every 
effort  and  every  element  which  entered  into  the  development 
of  a  property  should  be  considered  in  determining  its  actual 
cost,  and  in  the  same  way  I  believe  that  every  effort  and 
every  element  which  entered  into  the  cost  of  a  property 
should  appear  in  its  reproduction  cost,  but  that  there  should 
not  appear  also  the  cost  of  property  built  by  others  without 
any  effort  or  expense  to  the  company;  nor  should  there  be 
omitted  from  the  reproduction  cost  those  efforts  and  elements 
of  cost  which  entered  into  the  development  of  a  property 
because,  owing  to  the  action  of  others,  the  property  coidd 
be  reproduced  under  the  conditions  existing  at  the  present 
time  with  less  effort  and  cost. 


The  example  most  frequently  cited  of  an  increase  in 
reproduction  cost  under  existing  conditions  is  afforded  where 
a  water  or  gas  company  has  laid  a  pipe  in  an  unpaved  street 
which  has  subsequently  been  paved  by  a  city,  and  the 
increase  in  cost,  due  to  work  performed  by  others,  is  repre- 
sented by  the  cost  of  taking  up  and  replacing  the  pavement, 
an  operation  which  clearly  would  be  necessary  under  existing 
conditions. 

The  most  common  example  of  a  decrease  in  reproduction 
cost  under  existing  conditions  is  afforded  in  many  instances 
in  the  far  west  where  dams,  reservoirs,  hydro-electric  plants 
and  other  utiUties  have  been  built  far  from  lines  of 
transportation  and  subsequently  have  been  provided  with 
nearby  transportation  through  the  efforts  of  others.  In 
such  cases  the  reproduction  cost  under  existing  conditions 
is  greatly  decreased  through  improved  transportation  facili- 
ties for  which  the  owner  of  the  dam,  reservoir  or  hydro- 
electric plant  is  in  no  way  responsible. 

The  highest  court  has  decided  that  paving  laid  by  a  city 
after  the  pipes  are  laid  by  a  company  does  not  increase  the 
value  of  the  pipe,  even  if  it  does  increase  the  reproduction 
cost  under  the  usual  definition.  If  the  reproduction  cost 
were  determined  upon  the  basis  of  the  original  physical 
conditions,  the  court  would  not  have  to  make  a  distinction 
between  value  and  cost  in  such  a  case. 

When  one  takes  into  consideration  various  kinds  of 
public  service  properties,  hundreds  of  instances  may  be 
found  in  which  the  use  of  existing  conditions  in  determining 
the  reproduction  cost  produces  results  which  do  not  represent 
value,  under  the  principle  enunciated  by  the  courts  in  the 
case  of  paving,  and  this  necessity  for  making  a  distinction 
between  value  and  cost  would  disappear  if  the  reproduction 
cost  were  determined  under  the  original  physical  conditions. 
This  method  offers  a  greater  protection  to  the  actual  invest- 
ment and  prevents  the  inclusion  in  cost  of  unearned  incre- 
ments and  decrements. 

It  is  reasonable  to  assume  that  the  original  conception  of 
reproduction  cost  related  to  the  reproduction  cost  of  an 
existing  structure,  as,  for  instance,  a  building,  and  the 
question  arose  as  to  whether  such  a  building  would  cost 
more  or  less  under  the  prices  of  labor  and  material  at  the 
date  of  valuation. 

Under  modern  conditions  the  problem  has  become  much 
more  complicated.  Great  properties  are  created  at  the 
present  day  by  destroying  vast  amounts  of  existing  property, 
as,  for  example,  in  the  construction  of  the  great  water  works 
reservoirs  of  New  York  and  Boston.  In  such  cases  mills 
and  water  rights  were  destroyed,  towns  were  wiped  out, 
railroads  and  highways  were  relocated,  and  under  recent 
legislation  not  only  was  the  builder  of  the  reservoir  required 
to  pay  compensation  for  physical  property  destroyed,  but 
also  to  pay  incidental  damages  to  people  who  could  not 
claim  damages  under  the  common  law.  It  is  recognized 
in  these  cases  that  the  destruction  of  mill  and  other  kinds 
of  business  affected  the  employees  who  lost  their  positions 
and  those  who  owned  land  and  did  business  in  adjacent 


ORIGINAL   COST 


57 


territory.     These  incidental  damages  due  to  the  destruction 
of  business  amounted  to  large  sums. 

If  one  were  to  ascertain  the  reproduction  cost  of  such 
properties  under  conditions  which  now  exist,  there  would 
evidently  be  no  business  or  mills  or  water  rights  to  destroy, 
and  one  who  follows  strictly  the  reproduction  theory  under 
existing  conditions  would  necessarily  omit  large  and  proper 
costs  for  these  purposes  in  making  his  estimate. 

As  a  matter  of  general  practice,  those  who  nominally  base 
their  estimates  of  reproduction  cost  upon  existing  physical 
conditions  do  not  adhere  to  the  theory,  but  inconsistently 
use  the  original  or  historical  conditions  and  include  a  large 
amoimt  of  cost  which  would  be  excluded  if  the  existing 
condition  theory  were  strictly  adhered  to. 

As  a  simple  example  of  the  inconsistency  of  the  ordinary 
practice  of  ascertaining  the  reproduction  cost  under  existing 
conditions,  let  us  suppose  that  a  water  or  gas  pipe  has  been 
laid  in  a  street  before  it  was  paved,  and  assume  further 
that  the  street  is  composed  of  rock.  When  the  work  was 
originally  done  the  original  cost  included  the  blasting  of 
a  trench  in  the  rock,  the  laying  of  the  pipe,  the  refilling  of 
the  trench  with  earth,  and  the  resurfacing  of  the  street. 
Let  it  be  assumed  that  before  the  time  for  estimating  the 
cost  of  reproduction  the  surface  of  the  street  has  been 
covered  with  a  modem  pavement.  Under  the  conditions 
existing  at  the  time  of  estimating  the  reproduction  cost, 
it  would  be  necessary  in  order  to  reproduce  the  pipe  under 
the  existing  conditions  to  cut  the  pavement,  dig  the  earth 
from  the  trench,  place  the  pipe,  refill  the  trench  with  earth, 
and  replace  the  pavement.  That  would  be  the  actual 
process  if  the  pipe  were  to  be  replaced  at  that  time. 

In  accordance  with  current  practice,  the  estimator  figures 
the  cost  of  removing  and  replacing  the  pavement.  Then, 
instead  of  being  consistent  and  estimating  the  cost  of  excavat- 
ing and  replacing  the  earth,  he  resorts  to  the  historical 
conditions  and  estimates  the  cost  of  excavating  the  rock 
and  refilling  the  trench  with  earth. 

It  is  not  only  in  connection  with  the  physical  property  that 
the  use  of  the  original  physical  conditions  in  determining 
the  cost  of  reproduction  will  produce  equitable  results, 
but  the  use  of  original  conditions  will  also  produce  equity 
in  connection  with  the  overhead  charge  for  interest  dur- 
ing construction  and  the  less  tangible  cost  of  developing  the 
business. 

Under  the  original  conditions,  in  the  case  of  a  property 
which  has  started  from  a  small  beginning,  there  would 
be  the  interest  during  construction  for  about  half  the  period 
occupied  in  the  building  of  the  original  works;  then,  as  the 
property  grew  by  the  addition  of  small  parts  which  were 
put  into  use  as  soon  as  finished,  as,  for  instance,  the  additional 
pipes  laid  in  streets  to  supply  a  growing  town  or  city  with 
water,  there  would  be  the  interest  during  the  comparatively 
short  construction  period  required  for  each  of  such  additions. 
Equitable  treatment  requires  that  the  owners  of  the  property 
should  be  allowed  interest  during  construction  only  for  the 
time  properly  attributable  to  the  construction  of  the  various 
parts  of  the  works.     There  may  be  large  additions  to  a 


property,  requiring  many  years  for  their  construction,  and 
whatever  the  historical  period  may  be  for  such  construction, 
a  similar  period  should  be  allowed  in  determining  the  interest 
during  construction  for  that  part  of  the  property. 

When  the  interest  during  construction  is  determined  under 
existing  conditions,  it  is  the  usual  custom  to  deal  with  a 
hypothetical  period  for  reproducing  the  whole  of  an  existing 
property  at  one  operation,  and  the  result,  as  a  rule,  is  to 
greatly  lengthen  the  time  of  construction  for  which  the 
interest  should  be  computed,  thereby  furnishing  an  incre- 
ment of  interest  which  has  no  counterpart  in  a  property 
which  has  been  built  up  from  small  beginnings. 

The  same  reasons  which  require  the  use  of  original  con- 
ditions for  determining  the  time  to  be  allowed  in  determining 
the  interest  during  construction  also  require  the  use  of 
original  conditions  in  determining  the  cost  of  developing 
the  business,  but  I  will  not  elaborate  this  feature  as  I  have 
already  taken  too  much  time. 

Hon.  John  M.  Eshleman,  Formerly  President  of  California 
Railroad  Commission: 

I  think  the  force  of  some  of  the  ideas  that  have  been  pre- 
sented here  has  not  been  appreciated.  No  one  has  said 
that  the  historical  method  of  reproduction  is  unethical. 
Some  of  us  did  say,  however,  that,  to  take  that  as  to  a  part 
of  the  property  and  reject  it  as  to  another  important  part 
is  not  only  unethical  but  inconsistent;  and  the  historical 
method  of  reproduction  is  never  carried  out — never  has,  in 
my  experience,  been  carried  out  consistently  by  the  engineers 
or  by  the  representatives  of  the  utilities.  In  other  words, 
what  we  are  complaining  against,  is  their  desire  to  know 
history  when  history  will  do  something  for  them,  but  to 
forget  history  with  reference  to  lands  and  things  of  that 
sort  where  there  has  been  a  great  amount  of  apprecia- 
tion. Just  exactly  this  inconsistency  runs  through  all  the 
valuations. 

Now  the  suggestion  that  this  theory  came  from  represen- 
tatives of  the  people,  I  think  is  more  or  less  correct;  and  the 
distinguished  gentleman  who  first  advocated  it  agreed  it 
had  some  evils.  That  doesn't  make  it  any  more  logical 
or  binding  upon  me  than  it  does  upon  him.  I  think,  in 
frankness,  we  ought  to  say  that  there  has  been  a  desire  on 
the  part  of  some  people  representing  the  public  to  adopt 
this  method  because  they  thought  it  gave  them  the  best 
of  it;  and  there  has  been  a  desire  on  the  part  of  some  general 
utilities  to  adopt  it  now  (although  they  protested  strenuously 
against  it  originally),  when  they  find  it  gives  them  the 
better  of  it. 

I  think  that  cost,  the  measure  of  what  was  sacrificed, 
should  have  a  great  bearing  upon  the  amount  upon  which 
returns  are  to  be  allowed. 

Mr.  Stevens: 

It  is  always  an  ungrateful  task  to  explain  what  you  mean. 
My  remarks  regarding  the  origin  of  the  reproduction  theory 
were  really  directed  at  just  one  point,  which  I  consider  the 


58 


THE      UTILITIES      MAGAZINE 


weakness  of  the  whole  discussion,  so  far  as  I  have  heard 
it.  The  argument  is,  that  the  rates  should  be  based  upon 
some  ethical  theory.  Correct,  I  agree.  The  trouble  is,  that 
there  is  no  agreement  upon  what  the  ethical  basis  is — any 
more  than  upon  the  definition  of  the  word  "value."  There 
is  no  basis  of  ethics  which  is  universally  adopted  or  agreed 
upon;  and  when  you  say  that  you  want  to  put  it  upon  the 
ethical  theory,  you  simpy  get  into  the  quagmire  and  the  bog 
of  discussions  without  end. 

I  want  to  call  attention  to  just  one  fact  further  (if  you  will 
pardon  me),  which  I  should  have  cited  before.  Lately  there 
has  been  a  red  lantern  or  a  red  flag,  waved  by  day  or  by  night 
as  the  case  might  be,  over  the  fact  that  the  public  would 
get  no  services  from  the  railroads  if  the  appreciation  in  the 
value  of  the  lands  was  allowed,  because  the  rates  would 
get  so  high  that  nobody  could  pay  them.  That  is  the 
language,  almost  exactly,  of  Commissioner  Thelan  of  Califor- 
nia. 

Now  the  difficulty  that  I  find  with  some  of  these  matters 
is  that  theories  don't  agree  with  facts.  The  talk,  the  reason- 
ing, the  logic  of  the  thing  do  not  agree  with  the  exact  facts 
we  find  in  the  world  outside.  Land  has  been  appreciating 
in  value  in  this  country  for  a  good  many  years.  I  simply 
ask  the  gentlemen  to  draw  upon  the  same  sheet  of  paper, 
curves  (as  I  have  done)  showing  what  the  increase  in  the 
value  of  land  has  been;  and  you  will  find  it  would  be  going 
up — continually  going  up.  If  upon  the  same  sheet  of  paper 
you  will  draw  the  line  showing  what  the  cost  of  transportation 
has  been,  the  curve  is  going  down. 

Now,  when  the  first  road  went  through  so  that  there  was 
rail  connection  from  New  York  to  Chicago,  what  was  the 
rate  per  ton-mile.''  In  1854  you  will  find  it  was  three  and 
one-half  cents  per  ton-mile.  Land  was  cheap.  In  1910, 
over  the  same  road,  the  average  cost  per  ton-mile  for  freight 
was  5.23  mills  per  ton-mile.  Land  was  high.  Something 
has  been  forgotten  in  the  calculation;  what  is  it?  I  have 
not  the  density  of  the  traffic  in  1854;  but  upon  one  of 
the  principal  roads  leading  from  New  York  to  Chicago — 
I  refer  to  the  Lake  Shore  &  Michigan  Southern — the  density 
of  traffic  in  1870,  when  the  rate  per  ton-mile  was  IJ^  cents, 
was  566,635  tons.  In  1910,  when  it  was  half  a  cent  per 
mile,  the  density  of  traffic  was  4,055,517  tons. 

Mr.  Robert  L.  Hale,  Lecturer  in  Economics,  Columbia 
University: 

Any  fair-minded  person  who  has  listened  to  the  discus- 
sion must  be  convinced  that  actual  cost,  not  reproduction 
cost,  is  the  amount  on  which  a  fair  return  should  be 
allowed  on  future  investments.  If  we  can  warn  people 
not  to  pay  more  for  stock  than  actual  cost — warn  them 
that  earning  capacity  value  will  never  be  allowed  to  get 
ahead  of  actual  cost,  then  we  shall  avoid  the  dilemma 
we  now  have  to  face  as  to  existing  investments.  In  the 
case  of  existing  investments  where  we  have  j)ermitted  the 
exchange  value  to  grow  beyond  actual  cost,  it  is  often 
impossible  to  distinguish  between  those  stockholders  who 
invested  at  actual  cost  and  those  who  bought  their  stock 
later  at  the  advanced  value — the  "widows  and  orphans," 


in  other  words.  To  do  justice  to  the  "widows  and  orphans" 
it  would  be  necessary  to  make  the  consumers  pay  unfairly 
high  prices  to  the  holders  of  stock  who  paid  only  the  actual 
cost  for  it.  We  shall  have  to  work  hardship  on  one  of  two 
innocent  classes  of  persons — the  "widows  and  orphans"  or 
the  consumers^ — ^unless,  indeed,  we  make  the  taxpayer  bear 
this  burden.  Unless  we  adopt  this  last  course,  the  best  we 
can  do  is  to  find  an  arbitrary  amount  for  each  existing 
company,  between  the  actual  cost  as  the  lower  limit,  and 
the  present  exchange  value  as  the  upper  limit.  Whatever 
figure  is  adopted  between  these  limits  can  be  objected  to, 
but  some  figure  must  be  taken.  Having  taken  it,  we  can 
treat  the  future  as  an  entirely  separate  question  and  can 
warn  the  widow  and  the  orphan  never  to  buy  stock  at  any 
figure  above  what  we  have  adopted — unless  additional  cost 
has  been  incurred  since  the  time  when  we  adopted  our 
arbitrary  figure.  In  that  case,  we  can  make  it  known 
definitely,  through  control  and  publicity  of  accounts,  just 
what  additions  will  be  allowed.  In  the  case  of  companies 
started  after  the  warning  has  been  given,  it  can  be  known 
definitely  in  the  same  way  what  the  actual  cost  is  at  any 
time,  and  known  that  earnings  will  not  be  permitted  which 
would  increase  the  market  value  beyond  this  actual  cost. 
To  bring  about  this  separate  treatment  for  the  unwarned 
past  and  the  warned  future  will  require  a  statute.  Without 
such  a  statute  any  attempt  to  prevent  the  private  appro- 
priation of  unearned  increments  will  meet  the  opposition 
of  those  who  feel  sympathy  for  the  widows  and  orphans  class. 
By  being  generous  to  that  class,  while  at  the  same  time 
preventing  it  from  increasing,  there  will  be  much  more 
chance  of  getting  future  increments  for  the  public,  other- 
wise regulation  will  be  a  failure. 

O.  F.  Gayton,  Valuation  Supervisor,  Chicago,  III.: 
It  seems  that  we  are  rather  incUned  to  decide  that  the 
figure  a  city  should  base  the  rates  on  must  be  determined 
by  a  method  of  past  cost  rather  than  any  other  method. 
In  this  connection  I  wish  to  call  your  attention  to  certain 
legislation  of  the  State  of  Pennsylvania. 

Back  in  1874  a  law  was  passed  under  which  a  city  must 
pay  the  past  cost  in  order  to  purchase  a  pubUc  utility  plant. 
In  the  case  of  a  certain  waterworks  in  the  State  of  Pennsyl- 
vania the  figure  arrived  at  (which  was  a  million  dollars 
larger  than  the  actual  value  of  the  plant),  was  so  high  that 
the  city  could  not  think  of  purchasing  the  plant  as  high 
enough  rates  to  pay  ordinary  interest  on  the  figure  determined 
by  past  cost  could  not  be  charged. 

Dr.  Bemis: 

I  had  to  omit  a  good  many  quotations;  and  in  my  refer- 
ence to  Mr.  Stevens  I  omitted  certain  full  extracts  that  I 
was  referring  to;  or  I  think  he  would  not  have  thought 
that  I  did  any  injustice  to  his  position  in  those  famous 
cases  in  Buffalo,  and  still  held  by  him,  he  says,  as  to  the 
weakness  of  the  reproductive  theory.  As  to  his  second 
argument,  that  the  land  has  risen  in  value  and  railroad 
rates  have  fallen,  there  is  no  doubt  of  it.  But  that  does  not 
interfere  with  the  proposition:  that  if  the  present  value  of 


FRANCHISE      VALUES 


59 


the  land  is  taken  in  this  valuation  work,  it  will  simply  mean 
a  much  higher  value  than  is  generally  realized  and  will  be 
considered  a  justification  for  much  higher  rates  than  are 
now  being  charged.     The  situation  is  very  threatening. 

Mb.  Anderson: 

A  single  word  in  closing:  Mr.  Bemis'  spaper  and  the  dis- 
cussion, to  my  mind,  but  lend  emphasis  to  what  I  have 
already  in  substance  said, — the  hopeless  absurdity  of  find- 
ing any  sane  and  workable  basis  for  rates  in  any  possible 


definition  or  description  of  "fair  value  of  the  property 
used."  Archimedes  said  that  if  he  could  find  a  iron  stw  he 
could  move  the  world.  You  will  find  no  irofi  stco  for  rate 
making  within  "fair  value  of  the  property  used"  or  repro- 
duction cost.  There  will  be  no  motion  towards  a  sane  and 
workable  rate  making  theory  until  we  cut  entirely  loose 
from  our  absurd  reasoning  in  a  circle  and  ground  our  theory 
upon  the  real  basis  of  the  origin  and  increase  of  privately- 
owned  utilities,  to  wit, — ^the  contributions  of  the  investing 
public. 


PRINCIPLES  AS  TO  FRANCHISE  VALUES 


By  Delos  F.  Wilcox,  Ph.D. 

Consulting  Franchise  and  Public  Utility  Expert,  New  York  City;  Deputy  Commissioner,  Department  of  Water  Supply,  Gas  and  Ele<^ricity 

A    T  THE  outset  of  the  discussion,  we  ought  to 


clear  up  one  confusion  that  still  lingers  to 
plague  appraisers.  Under  the  stress  of  public 
regulation,  the  protagonists  of  vested  rights  have  dis- 
covered many  new  elements  of  value  in  public  utility 
properties.  In  this  matter  danger,  if  not  necessity, 
has  been  the  mother  of  invention.  At  the  present  time 
we  need  to  fear,  not  that  some 
elements  of  value  will  be  over- 
looked, but  that  the  appraiser's 
eye,  after  being  shown  the  mul- 
tifarious riches  of  the  public 
utility  world  from  the  top  of  a 
high  mountain,  will  see  double. 
In  considering  franchise  values, 
we  must  not  forget  that  the 
first  and  principal  function  of 
a  franchise  is  to  give  life  and 
value  to  the  physical  property. 
A  franchise  is  needed  for  this 
purpose  because  without  it  the 
physical  property  itself  is  a 
trespasser.  In  public  utilities, 
therefore,  a  franchise  is  needed 

to  give  the  physical  structures  a  value  which,  in  purely 
private  enterprises,  they  would  have  without  a  fran- 
chise. It  is  absolutely  unsound  to  assign  to  the  franchise 
great  value  on  the  ground  that  without  it  the  physical 
property  would  be  scrap,  and  then,  on  top  of  this  valua- 
tion, to  allow  full  going  value  to  the  physical  property 
as  if  without  the  franchise  it  were  not  scrap  after  all. 
This  is  sheer  duplication  and  is  inexcusable  for  any 
purpose  whatever. 

While  it  is  much  to  be  desired  that  the  principles  of 
valuation  should  be  made  as  nearly  uniform  as  possible 
so  as  to  reduce  the  existing  chaos  in  valuation  matters 


PART  III 
FRANCHISE  VALUES 


to  a  minimum,  yet  for  the  present  it  is  impracticable 
to  apply  strictly  uniform  principles  to  valuations  for 
such  widely  different  purposes  as,  (1)  taxation;  (2) 
rate-making;  (3)  condemnation;  (4)  involuntary  sale; 
(5)  voluntary  purchase;  and  (6)  capitalization.  Taking 
up  these  several  purposes  seriatim,  we  may  consider  the' 
principles  as  to  franchise  values,  giving  due  considera- 
tion to  the  character,  duration 
and  terminability  of  the  fran- 
chise in  each  case. 


PRINCIPLES  AS  TO  FRANCHISE  VALUES  FOR 
TAXATION 
RATE  MAKING 
CONDEMNATION 
INVOLUNTARY  SALE 
VOLUNTARY  PURCHASE 
CAPITALIZATION 


LEGAL  VS.  ADMINISTRATIVE  PHASES  OF 
FRANCHISE  VALUATION 


FRANCHISE    VALUES 
FOR  PURPOSES  OF 
TAXATION 


It  is  now  well  established 
that  it  is  admissible  to  tax 
franchise  values  whenever  and 
wherever  they  exist,  without 
reference  to  the  possibility  of 
their  being  reduced  or  des- 
troyed in  the  future,  whether 
by  expiration,  by  regulation  of 
rates  and  services,  by  decrease 
in  demand,  by  increase  in  ex- 
penses, or  by  other  causes.  It  is  to  be  noted,  however, 
that  in  establishing  a  value  for  taxing  purposes,  when 
the  tax  is  first  imposed,  if  the  taxing  officials  assess  the 
franchise  at  its  full  market  value  as  untaxed  property, 
the  imposition  of  the  tax  will  automatically  reduce  this 
value  and  thereby  reduce  the  assessment  for  the  suc- 
ceeding year  and  thereby  reduce  again  the  amount 
paid  in  taxes,  which  in  turn  will  have  the  effect  of 
giving  back  a  portion  of  its  original  value  to  the  fran- 
chise. This  oscillation  can  be  prevented  if  the'effect  of 
the  tax  is  discounted  in  advance. 

It  may  be  that  a  franchise  is  worth  much  less  than 


60 


THE      UTILITIES      MAGAZINE 


it  originally  cost,  or,  indeed,  much  less  than  it  would 
cost  to  "reproduce"  it.  Present  value  for  taxing  pur- 
poses is  not  to  be  determined  either  by  actual  cost  or 
by  assumed  reproduction  cost.  The  most  widely 
accepted  method  of  ascertaining  franchise  values  for 
taxing  purposes  is  the  so-called  "net  earnings"  method. 
From  the  gross  earnings  of  the  corporation  are  deducted, 
first,  operating  expenses,  depreciation  and  taxes  and, 
second,  a  fair  minimum  rate  of  return  upon  the  value 
of  all  the  physical  property  used  and  useful  in  render- 
ing the  service.  Whatever  is  left  represents  the  earn- 
ings of  the  franchise  and,  if  capitalized,  will  represent 
the  value  of  the  franchise.  Thus,  the  value  of  a  fran- 
chise for  taxation  purposes  is  to  be  determined  primarily 
by  its  earning  power,  which,  in  turn,  usually  is  the 
main  factor  in  establishing  its  market  value. 

One  limitation  upon  the  net  earnings  method  of 
determining  the  value  of  a  franchise  for  taxation  pur- 
poses should  be  noted.  Speaking  generally,  the  present 
value  of  the  land  used  and  useful  in  the  operation  of  a 
public  utility  is  to  be  taken  in  determining  the  value  of 
the  physical  property  upon  which  a  fair  return  must  be 
allowed  out  of  earnings  before  getting  the  net  earnings 
of  the  franchise.  It  appears,  however,  that  if  for  any 
reason  the  present  value  of  the  land,  as  distinguished 
from  its  cost  to  the  owner  of  the  utility,  has  become  so 
great  as  to  make  it  out  of  all  proportion  to  the  value  of 
the  plant  as  a  whole,  especially  if  by  a  readjustment 
cheaper  lands  could  be  had  suitable  for  the  purpose, 
somewhat  less  than  the  full  present  value  of  the  land 
may  be  taken. 

In  New  York  a  secondary  franchise  is  defined  as  the 
right  to  occupy  public  streets  with  fixtures.  This  right 
is  classified  as  real  estate.  It  is  an  easement — one  of 
the  elements  isolated  and  taken  out  of  the  aggregate 
value  of  the  land  in  the  public  highways.  The  pipes, 
wires,  conduits,  tracks  and  other  public  utility  fixtures 
located  in  the  streets  are  also  real  estate,  corresponding 
to  buildings  and  other  improvements  on  land.  The 
right  and  the  fixtures  together  constitute  the  "special 
franchise,"  which  is  taxed  as  ordinary  real  estate,  but 
is  assessed  in  a  different  way.  In  New  York,  therefore, 
when  we  speak  of  the  principles  of  franchise  valuation 
for  taxing  purposes,  we  are  sure  to  be  misleading  unless 
we  are  very  precise.  While  it  seems  to  be  the  theory 
of  the  state  board  of  tax  commissioners  that  the  value 
of  the  "special  franchise"  should  never  be  less  than  the 
present  value  of  that  portion  of  it  constituted  by  the 
physical  structures,  it  nevertheless  frequently  happens 
that  the  assessment  of  the  intangible  right  plus  the 
tangible  improvement  of  such  right  is  less  than  the 
reproduction  cost  new  less  depreciation  of  the  improve- 
ment alone.     Under  such  conditions  it  might  be  said 


that  the  franchise — the  intangible  right — is  worth  less 
than  nothing  for  taxation  purposes. 

An  important  factor  in  the  determination  of  the 
value  of  the  franchise  for  taxation  purposes  is  the  ques- 
tion of  its  duration.  It  is  clear  that  its  duration  does 
not  directly  affect  the  earning  power  of  a  franchise  at 
the  particular  moment  when  it  is  assessed  for  taxation. 
The  effect  is  indirect.  Under  a  perpetual  franchise, 
or  under  an  indeterminate  or  a  limited  term  franchise 
that  provides  for  the  purchase  of  the  physical  property 
by  the  governmental  body  in  lieu  of  the  continuation 
or  renewal  of  the  franchise  itself,  with  the  security  to 
the  investment  resulting  from  these  conditions,  the 
rate  of  return  to  be  allowed  as  fair  and  reasonable  upon 
the  value  of  the  physical  property  will  be  lower,  and 
the  net  earnings  attributable  to  the  franchise  itself  will 
be  larger.  It  is  clear,  therefore,  that  for  taxing  pur- 
poses, even  under  the  net  earnings  theory  of  valuation, 
a  franchise  is  worth  more  in  proportion  to  its  assured 
duration  or  in  proportion  to  the  security  it  gives  to  the 
investment  in  the  physical  property.  Of  course,  if  the 
franchise,  in  addition  to  other  forms  of  security,  estab- 
lishes the  corporation's  right  to  charge  certain  fixed  and 
highly  profitable  rates  for  a  definite  term  of  years,  that 
fact  will  also  tend  to  enhance  the  value  of  the  franchise 
itself.  If,  on  the  other  hand,  the  rates  are  fixed  for  a 
definite  period  at  a  point  so  low  as  to  make  them  in- 
creasingly unprofitable,  as  the  business  develops,  as, 
for  example,  in  the  case  of  a  telephone  system  in  a 
rapidly  growing  city,  then  this  element  of  fixity  will 
tend  to  decrease  the  value  of  the  franchise  by  enlarging 
the  rate  of  return  which  the  corporation  for  the  present 
is  entitled  to  earn,  if  it  can,  upon  the  value  of  its 
physical  property.  Except,  however,  as  the  duration 
of  the  franchise  or  the  terms  and  conditions  under  which 
it  is  held  affect  the  security  of  the  property  itself  or  the 
security  of  its  earning  power,  and  thereby  decrease  or 
increase  the  fair  rate  of  return  which  the  corporation 
has  a  right  to  demand,  the  value  of  the  franchise,  if 
measured  by  the  net  earnings  theory,  will  not  be  affected 
by  the  duration  of  the  grant  or  by  the  fixity  of  the  rates. 
Indeed,  even  though  the  rates  charged  are  subject  to 
revision  and  control  by  the  public  authorities,  and 
even  if  the  rates  which  the  company  is  charging  at  the 
moment  of  the  valuation  for  taxing  purposes  are  exces- 
sive and  likely  to  be  reduced,  nevertheless  the  value  of 
the  franchise  at  that  moment  is  to  be  determined  by 
its  earning  power  under  the  rates  actually  charged,  and 
will  not  be  affected  by  the  possibility  or  even  the 
probability  that  rates  will  be  reduced  by  the  public 
authorities  in  the  future.  It  is  the  theory  that  any 
possible  reduction  of  rates  through  the  exercise  of  the 
rate  fixing  power  of  the  state  does  not  in  any  degree 
render  the  investment  itself  imsafe  or  add  an  element 


FRANCHISE      VALUES 


61 


of  danger  as  to  the  probability  of  the  corporation's 
continuing  to  earn  a  fair  return.  In  fact,  the  immi- 
nence of  regulation,  even  though  its  immediate  mani- 
festation is  likely  to  be  in  a  reduction  of  rates,  gives 
a  certain  promise  of  security  and  stability  to  the  prop- 
erty and  especially  to  its  earning  power,  which  naturally 
tends  to  lower  the  rate  of  return  and  thereby  to  enhance 
the  value  of  the  franchise.  Thus  we  see  that  for  taxing 
purposes  a  franchise  under  which  high  rates  are  charged 
is  to  be  valued  on  the  basis  of  these  high  rates,  and  if 
the  corporation  stands  a  good  chance  of  being  com- 
pelled to  reduce  its  rates  by  public  regulation,  then  this 
very  fact  will  tend  to  give  an  additional  element  of 
present  value  to  the  franchise,  for,  with  a  regulation  of 
rates,  goes  an  express  or  implied  protection  against 
competition,  while  high  rates  without  regulation  are  a 
continuing  invitation  to  competitive  undertaking. 

It  should  not  be  forgotten  that  one  of  the  most 
important  factors  in  the  consideration  of  the  safety  of 
the  investment  and  the  certainty  of  its  earning  power 
is  the  exclusiveness  or  non-exclusiveness  of  the  fran- 
chise. In  some  instances  franchises  are  absolutely 
exclusive.  In  others  they  are  practically  so,  as  the 
grantee  is  given  the  first  choice  for  all  extensions  and 
the  only  penalty  for  failure  to  take  the  extensions  is 
the  loss  of  the  exclusive  right  to  them.  This  loss  is 
usually  of  little  importance  if  the  extensions  are  not 
worth  taking  when  offered.  Furthermore,  in  those 
states  where  a  public  service  corporation  or  a  munici- 
pality desiring  to  establish  a  competitive  service  has 
to  get  from  a  state  commission  a  certificate  of  public 
convenience  and  necessity,  and  where,  in  practice,  the 
state  -has  committed  itself  to  the  policy  of  regulated 
monopoly,  these  conditions  themselves  establish  exclu- 
siveness of  existing  franchises  in  a  somewhat  mild  form. 

2.  FRANCHISE  VALUES  FOR  PURPOSES  OF 
RATE  MAKING 

No  more  important  or  more  critical  decision,  so  far 
as  the  theory  of  rate  regulation  is  concerned,  has  been 
reached  in  any  litigation  than  that  which  marks  the 
final  stage  of  the  Passaic  Gas  Case  in  the  courts  of 
New  Jersey.  In  December  last,  the  highest  New 
Jersey  court  reversed  the  Board  of  Public  Utilities  and 
the  lower  court  and  decided  that  in  determining  the 
valuation  of  the  gas  company's  property  for  the  purpose 
of  fixing  rates,  a  separate  and  distinct  allowance  should 
be  made  for  the  value  of  the  company's  franchises.  If 
this  decision  had  been  allowed  to  stand,  it  would  have 
•meant  that  in  New  Jersey,  at  least,  rate  making  would 
be  a  beggarly  business.  If,  as  was  pointed  out  in  the 
arguments  on  the  rehearing,  the  value  of  the  franchise 
is  determined  in  large  measure  by  the  rates  which  the 
corporation  charges,  and  if  this  value  in  turn  must  be 


added  as  a  separate  element  to  the  valuation  of  the 
physical  plant  in  determining  the  investment  basis  upon 
which  the  corporation  will  be  entitled  to  earn  a  fair 
return,  then  a  reduction  of  rates  by  public  authority 
will  be  clearly  impossible,  and  in  fact,  a  continual 
increase  in  rates  up  to  the  point  where  the  corporat'on 
collects  all  the  traffic  will  bear  or  to  a  point  where  the 
rate  is  inherently  unreasonable  in  relation  to  the  value 
of  the  service  rendered,  will  be  a  logical  necessity.  This 
is  especially  true  where  the  rate  fixing  authority  is  at 
all  liberal  in  determining  the  fair  rate  of  return  to  be 
allowed  on  the  investment.  For  if  a  return  of  8  per 
cent,  for  example,  is  allowed  on  a  valuation  which 
includes,  let  us  assume,  $1,000,000  for  the  franchise, 
then  straightway  the  franchise,  with  this  guaranty  of 
an  8  per  cent  earning  power,  will  be  greatly  enhanced 
in  value.  The  same  process  will  go  on  indefinitely  with 
every  revision  of  the  rates,  and  the  exercise  of  the  rate 
fixing  power  will  be  nothing  but  a  steady  climbing  of 
the  Golden  Stair,  or  Jacob's  Ladder,  if  that  is  preferred. 

Fortunately,  upon  the  rehearing,  the  New  Jersey 
court  of  Errors  and  Appeals,  thanks  to  a  change  in  the 
sitting  membership,  reversed  itself  and  its  earlier  deci- 
sion and  sustained  the  valuation  placed  upon  the  gas 
property  by  the  Board  of  Public  Utilities,  in  which  no 
separate  allowance  was  made  for  franchise  value.  It 
has  been  announced  that  the  Public  Service  Gas  Com- 
pany will  appeal  this  case  to  the  United  States  Supreme 
Court,  but  if  it  takes  such  action  we  may  reasonably 
suspect  that  the  company  is  more  interested  in  getting 
a  backhanded  confirmation  by  the  highest  court  in  the 
land  of  the  extraordinary  allowances  made  for  going 
value  in  the  New  Jersey  case,  than  it  is  hopeful  of 
inducing  the  Supreme  Court  to  sanction  its  prepos- 
terous claims  as  to  franchise  valuation  for  rate  purposes. 

It  is  true  that  the  astute  counsel  representing  the 
great  public  service  corporations  try  to  make  a  good 
deal  out  of  the  Supreme  Court's  hybrid  decision  in  the 
Consolidated  Gas  Case.  That  was  a  special  case  and 
the  court,  in  a  celebrated  dictum,  said  that  the  State  of 
New  York  could  not  now  question  the  valuation 
placed  at  the  time  upon  the  franchises  of  the  constituent 
companies  which  together  formed  the  Consolidated  Gas 
Company,  this  consolidation  having  been  effected  in 
accordance  with  the  terms  of  the  statute  authorizing 
the  consolidation.  The  court  stated  that  the  city 
could  not  deny  the  company's  right  to  earn  a  fair 
return  upon  the  value  of  its  franchises  as  measured  and 
capitalized  under  state  protection,  but  it  likewise  stated 
that  to  allow  an  increase  in  this  value  in  a  rate  case 
would  be  subversive  of  fundamental  legal  assumptions. 

It  may  be  considered  as  reasonably  well  settled  in  the 
courts  that  in  a  rate  proceeding  no  separate  and  distinct 
value  need  be  assigned  to  the  corporation's  franchises 


62 


THE      UTILITIES      MAGAZINE 


except  in  those  peculiar  cases  where  these  values  have 
been  measured  and  capitahzed  by  authority  of  the 
state  itself.  Specifically  and  definitely,  the  fact  that 
the  state  has  valued  the  franchises  for  taxing  purposes 
has  no  significance  in  a  rate  case,  for,  as  the  courts  hold, 
rates  are  subject  to  revision,  while  for  taxation  pur- 
poses present  values  may  be  assessed  wherever  they 
are  found,  without  reference  to  what  may  become  of 
them  in  the  future.  If  the  rates  are  reduced  and  the 
franchise  values  shrink,  then,  naturally,  when  the  next 
assessment  for  taxation  is  made,  the  valuation  will  be 
correspondingly  lowered. 

Two  points  of  special  diflBculty  arise  in  this  con- 
nection. Under  a  franchise  by  which  the  rates  are 
fixed  for  a  definite  term  of  years  by  agreement  between 
the  municipality  and  the  grantee,  we  are  saved  the 
trouble  of  laying  down  principles  of  valuation  for  rate 
making,  inasmuch  as  the  rates  are  fixed  and  no  rate 
regulation  is  possible.  This  statement  requires  serious 
modification,  however.  While  the  courts  will  hold, 
as  in  the  Minneapolis  Street  Railway  Fare  Case,  that 
the  municipality  itself  is  bound  not  to  reduce  rates 
fixed  by  the  franchise  contracts,  they  will  also  hold, 
as  they  have  done  in  Wisconsin,  in  Washington  and 
in  New  York,  that  rates  fixed  by  contract  between  the 
public  service  corporation  and  the  municipality  are 
not  immune  from  regulation  by  the  state  unless  the 
municipality,  when  it  entered  into  the  contract,  had 
been  delegated  specific  authority  by  the  state  to  fix 
the  rates  by  contract  for  a  definite  term  of  years.  It 
appears  that  the  recent  trend  of  decisions  is  against 
the  assumption  that  rates  established  by  a  franchise 
lie  outside  the  pale  of  state  regulation.  In  other 
words,  the  courts  tend  to  keep  available  wherever 
possible  the  authority  of  the  state  under  the  police 
power  to  enforce  reasonable  rates  for  public  utility 
services. 

The  other  point  of  difficulty  in  the  valuation  of 
franchises  for  rate  purposes  relates  to  the  question  of 
compensation  originally  paid  by  the  corporation  or 
its  predecessor  to  the  municipality  in  consideration  of 
the  grant  of  the  franchise.  From  this  point  of  view 
it  may  be  considered  fortunate  that  the  cases  where 
public  utilities  have  paid  lump  sums  of  any  importance 
for  their  franchise  rights  are  comparatively  rare,  and 
so  this  difficulty,  though  important  in  its  principle, 
is  a  minor  one  in  practice.  However,  the  problem 
needs  to  be  solved.  It  may,  perhaps,  be  said  that 
where  the  valuation  of  the  property  for  rate  purposes 
is  based  strictly  upon  the  reproduction-cost-less- 
depreciation  method,  no  weight  can  be  given  to  the 
fact  that  in  the  particular  case  a  large  sum  may  have 
been  paid  for  the  franchise  originally,  except  as  this 
is  evidence  of  what  it  would  cost  to  "reproduce"  it. 


However,  the  obvious  uncertainty  of  reproduction 
cost  so  far  as  franchises  are  concerned  makes  this 
method  for  franchise  purposes  inapplicable. 

Where  the  value  of  the  franchise  is  allowed  in  a  rate 
case  it  must  be  based  upon  actual  cost  or  assumed 
actual  cost,  without  depreciation  where  the  franchise 
is  perpetual,  and  depreciated  in  proportion  to  its 
years  where  its  life  is  limited. 

3.   FRANCHISE    VALUES  FOR    PURPOSES    OF 
CONDEMNATION 

In  a  condemnation  proceeding  there  is  a  determina- 
tion on  the  part  of  the  public  that  the  acquisition  of 
the  plant  is  a  public  necessity.  It  is  assumed  that 
the  acquisition  of  the  property  is  carried  through 
against  the  will  of  the  owner,  although  in  some  cases 
the  owner's  opposition  is  little  more  than  formal. 
Fair  value  will  not  be  determined  as  the  price  paid 
by  a  willing  buyer  to  a  willing  seller,  but  rather  the 
price  to  be  paid  to  an  unwilling  seller  when  public 
necessity  requires  that  his  property  be  taken  for 
pubhc  use. 

The  valuation  of  a  franchise  in  condemnation  pro- 
ceedings is  a  rhatter  of  special  difficulty.  What  it 
cost  originally  is  of  no  moment.  What  it  would  cost 
to  reproduce  it  is  almost  as  immaterial.  The  present 
worth  of  its  prospective  earning  power  is  the  real 
criterion,  but  this  standard  of  judgment  is  rendered 
doubtful  because  of  the  uncertainty  as  to  future  rates. 
It  has  been  a  matter  of  dispute  whether,  in  a  con- 
demnation case,  the  value  of  the  franchise  should  be 
based  upon  the  assumption  that  existing  rates  will 
be  continued  indefinitely,  or  whether,  on  the  other 
hand,  it  should  be  based  upon  the  assumption  that 
only  a  fair  rate  will  be  permitted.  Inasmuch  as  the 
investment  in  a  public  utility  is  devoted  to  a  public 
use  and  is,  therefore,  subject  to  certain  burdens  and 
limitations,  it  would  seem  that  the  rules  of  valuation 
ought  to  presume  only  fair  and  reasonable  rates  and 
ought,  therefore,  to  discount  the  apparent  but  largely 
fictitious  value  which  would  naturally  be  reflected  in 
the  earning  power  of  the  franchise  while  the  utility 
continues  to  charge  excessive  rates  without  govern- 
mental interference.  In  this  respect  valuation  for 
condemnation  purposes  may  properly  be  distinguished 
from  valuation  for  taxation  purposes.  The  theory  is 
that  in  condemnation  the  pubhc  authorities  take 
away  the  entire  property,  including  all  its  future 
earning  power,  while  in  taxation  they  merely  take 
a  portion  of  the  earning  power  for  the  current  year, 
and,  if  the  earning  power  in  succeeding  years  is  dimin- 
ished, they  will  then  take  less. 

It  is  for  the  purpose  of  condemnation  that  the 
character  and  duration  of  the  franchise  have  the  greatest 


FRANCHISE      VALUES 


63 


significance.  If  the  franchise  fixes  the  rates  beyond 
the  power  of  the  state  or  of  the  grantee  to  revise  them, 
then  the  character  of  the  rate  so  fixed  will  be  the  most 
important  element  in  the  determination  of  the  value 
of  the  franchise.  If  the  rate  is  so  low  that  the  grantee 
is  losing  money  and  is  bound  to  lose  money  under 
future  conditions,  the  franchise  is  properly  regarded 
as  a  liability  rather  than  an  asset.  If,  on  the  other 
hand,  the  rate  is  higher  than  necessary  to  secure  a 
fair  return  upon  the  actual  investment  plus  any  amor- 
tization reserves  that  may  be  required  to  safeguard 
the  capital,  then  the  franchise  is  an  asset  and  its  value 
is  to  be  measured  by  the  present  worth  of  its  prospective 
earning  power.  Accordingly,  while  the  fixed  character 
of  the  rates  has  great  influence  upon  the  value  of  the 
franchise  for  condemnation  purposes,  this  influence 
will  not  always  be  in  the  same  direction.  The  fixed  rate 
may  in  some  cases  prove  to  be  a  disadvantage  to  the 
corporation. 

Of  course,  we  should  not  consider  the  rate,  where 
that  is  fixed  by  the  contract,  apart  from  the  other 
conditions  of  the  franchise,  particularly  those  relating 
to  service  or  contributions  to  the  public  treasury. 
A  rate  might  be  very  favorable  to  the  company  and 
yet  the  advantage  of  it  be  offset  by  onerous  terms  as 
to  compensation  or  as  to  service.  On  the  other  hand, 
a  rate  might  be  very  low  and  yet  its  disadvantages  to 
the  company  be  more  than  offset  by  the  release  of 
the  company  from  various  obligations  ordinarily 
assumed  by  a  franchise  holder.  A  good  illustration  is 
furnished  by  the  Pingree  three-cent  fare  lines  in 
Detroit.  Pingree  was  so  anxious  to  get  low  fares  and 
to  inaugurate  successful  competition  with  the  five-cent 
lines,  that  in  the  low  fare  franchise  he  bound  the  city 
to  construct  and  maintain  the  pavements  and  even  the 
foundations  of  the  tracks,  and  relieved  the  grantee 
from  a  part  of  the  usual  burdens  of  taxation.  These 
concessions  went  a  long  way  to  overcome  the  disad- 
vantages to  the  company  of  the  low  fare. 

In  this  connection,  also,  it  is  necessary  to  bear  in 
mind  that  in  almost  every  case  the  terms  of  the  fran- 
chise are  such  as  to  require,  or  at  least  not  to  preclude 
a  public  service  commission  from  requiring,  good 
service,  whether  it  is  profitable  or  not.  It  is  recognized 
as  one  of  the  fundamental  principles  of  public  utility 
regulation  that  the  rendering  of  adequate  service  to 
the  public  is  an  obligation  paramount  to  the  right  to 
earn  dividends  for  the  stockholders.  In  practical 
application,  however,  the  wind  is  usually  tempered  to 
the  shorn  lamb.  Certain  methods  of  controlling  serv- 
ice may  be  precluded  by  the  terms  of  the  contract. 
Extensions  and  improvements  that  would  be  highly 
advantageous  to  the  public  will  not  be  required  of  a 
utility  that  is  not  being  operated  at  a  profit,  so  long 


as  such  extensions  and  improvements  are  not  strictly 
essential  to  reasonably  good  service.  If,  however,  a 
franchise-holding  corporation  is  making  liberal  profits, 
under  the  protection  of  a  fixed  rate,  the  regulating 
authority  can  undoubtedly  require  a  much  higher 
standard  of  service  than  it  could  or  would  require  if 
the  property  was  being  operated  at  a  loss.  Therefore, 
even  where  a  liberal  rate  is  fixed  in  the  franchise  and 
cannot  be  reduced  by  any  power  in  the  state,  the 
present  worth  of  this  franchise  should  be  discounted 
to  a  certain  extent  in  consideration  of  the  fact  that 
by  regulation  the  surplus  profits  may  be  largely  diverted 
from  the  pockets  of  the  stockholders  by  the  requirement 
of  more  liberal  service.  In  all  cases,  except  for  taxing 
purposes  where  the  valuation  is  for  the  current  year 
only,  the  advent  of  the  public  regulation  idea  tends  to- 
ward a  very  conservative  valuation  for  franchises,  no 
matter  how  advantageous  they  may  appear  to  be  to  those 
who  hold  them. 

In  many  cases,  maximum  rates  only  are  fixed  as  a 
matter  of  contract.  In  many  other  cases  the  rates 
are  not  fixed  at  all.  Wherever  the  rates  are  left  to 
be  estabhshed  by  the  franchise  owner  or  by  a  regulating 
body  such  as  a  public  service  commission,  the  value  of 
the  franchise  will  be  measured  largely  by  the  security 
it  gives  to  the  investment.  This  in  turn  will  depend 
either  upon  its  duration  or  upon  the  conditions  that 
control  its  termination.  If  the  franchise  is  perpetual 
and  the  utihty  is  well  established,  so  that  it  promises 
to  continue  in  service  indefinitely,  the  necessity  of  an 
amortization  fund  is  eliminated.  The  investment  has 
been  made  and  presumably  will  be  kept  intact.  Under 
these  circumstances  the  investor  does  not  have  to 
worry  about  getting  his  money  back.  It  is  assumed 
that  the  money  will  always  be  needed  in  the  utility 
and  that  if  a  particular  investor  desires  to  withdraw 
his  contribution,  he  can  do  so  by  the  transfer  of  his 
securities  to  others.  He  does  not  have  to  get  his 
money  back  out  of  earnings.  A  franchise  of  this 
character  may  be  said  to  have  value,  but  its  chief 
value  consists  in  the  life  and  security  which  it  gives 
to  the  physical  property.  An  attempt  to  measure  its 
separate  value  on  the  basis  of  the  present  worth  of  its 
future  earnings  is  more  or  less  chimerical  and  is  almost 
certain  to  lead  to  an  overvaluation.  Even  future  gross 
earnings  are  a  matter  of  great  uncertainty,  depending 
upon  the  increase  of  population,  the  demand  for  the 
service,  possible  direct  or  indirect  competition  and  the 
rates  permitted  to  be  charged.  To  estimate  net 
earnings  is  still  more  diflBcult,  because  of  the  additional 
elements  of  uncertainty  in  the  matter  of  operating 
expenses,  depreciation  and  carrying  charges.  A  per- 
petual franchise  that  today  appears  to  be  an  asset  may, 
within  a  few  years,  become  a  liability  through  changes 


64 


THE      UTILITIES      MAGAZINE 


in  the  conditions  of  operation  and  in  the  measure  and 
methods  of  control  exercised  by  the  public.  Therefore, 
where  property  is  taken  for  a  necessary  public  use, 
even  though  the  owner  parts  with  it  unwillingly, 
the  valuation  of  the  franchise  should  be  very  con- 
servative, partly  because  of  the  extreme  uncertainty 
of  the  amount  of  future  net  earnings.  If  we  are  to  judge 
by  past  experience  and  present  tendencies,  it  may  be 
said  that  the  amount  of  future  net  earnings  is 
likely  to  be  less  than  any  definite  estimate  which  will 
be  made  on  the  basis  of  past  figures.  This  is  due 
partly  to  the  neglect  of  depreciation  in  the  past  and 
partly  to  the  constantly  increasing  expenditures  re- 
sulting from  higher  labor  costs,  higher  standards  of  ser- 
vice and  greater  interferences  with  operation  as  street 
congestion  increases. 

If  a  franchise,  having  a  limited  life,  contains  a 
provision  that  at  the  end  of  the  period  the  physical 
property  shall  be  purchased  by  the  city  or  by  some 
other  grantee  of  the  city,  this  fact  tends  to  put  the 
franchise,  so  far  as  valuation  is  concerned,  upon  a 
parity  with  a  perpetual  franchise;  for  under  both  of 
these  forms  of  franchise,  it  is  equally  unnecessary  to 
provide  for  an  amortization  fund  by  means  of  which 
the  investment  will  be  retired  out  of  earnings.  In 
fact,  such  a  limited  term  franchise  may  be  more  valuable 
than  a  perpetual  franchise,  for  under  it  the  investor  is 
sure  of  getting  his  money,  while  under  a  perpetual 
franchise  he  runs  the  risk  of  the  utility  itself  becoming 
obsolete  and  the  entire  investment  being  lost. 

If,  on  the  other  hand,  the  franchise,  like  most 
limited  term  grants,  makes  no  provision  by  which  the 
city  is  obligated  either  to  renew  the  grant  or  to  refrain 
from  building  a  new  plant  or  letting  somebody  else  do 
so,  then  the  investor,  as  a  matter  of  common  prudence, 
must  figure  on  taking  out  of  the  enterprise  from  year 
to  year  somewhat  more  than  a  fair  return  upon  his 
investment,  in  order  that  he  may  get  back  his  principal 
as  well  as  his  interest.  He  has  no  assurance  that  when 
the  grant  expires  his  property  will  not  be  reduced  to 
scrap  value.  Strictly  speaking,  therefore,  he  ought 
during  the  life  of  the  franchise  to  recover,  in  excess 
of  a  fair  return,  that  portion  of  his  investment  which 
represents  the  diflference  between  the  original  cost 
of  the  plant  and  its  ultimate  value  as  scrap.  In 
practice,  it  is  true  that  most  utility  owners  have 
trusted  to  luck  or  politics  to  get  their  franchises  renewed, 
or  have  put  their  dependence  upon  the  well-known 
difficulties  of  installing  a  competitive  service  and  upon 
the  relative  certainty  that  the  public  will  demand 
the  continuance  of  the  service  without  reference  to  the 
date  of  expiration  of  the  franchise.  Accordingly,  the 
investors  have  frequently,  if  not  generally,  assumed 
a  portion  of  the  risk  and  have  not  figured  upon  getting 


their  entire  investment  back  in  the  shape  of  excess 
earnings  during  the  term  of  the  franchise.  Doubtless 
in  many  cases  companies,  without  any  ultimate  security 
for  the  investment  itself,  have  accepted  franchises 
with  rates  and  other  obligations  so  fixed  as  to  make  it 
utterly  impossible  for  them  to  render  adequate  service, 
earn  a  fair  return  upon  the  investment  and  also  with- 
draw their  capital  out  of  earnings  during  the  franchise 
period.  If  a  company,  adopting  a  safe  and  con- 
servative policy,  succeeds  in  getting  its  investment 
back  before  the  expiration  of  the  franchise,  the  investors 
will  then  be  in  a  position  where  they  are  even  with 
the  world  and  in  addition  own  a  utility  plant,  with 
whatever  value  there  may  be  in  it.  They  will  have 
eaten  their  cake  and  still  have  it.  The  chances  are 
that  the  plant,  if  in  good  condition,  will  either  be 
purchased  by  the  city  or  will  continue  to  be  operated, 
with  or  without  a  franchise,  by  the  company.  So,  the 
corporation,  if  it  pursues  a  safe  policy,  stands  to  make 
an  unreasonable  profit.  If,  on  the  other  hand,  it 
decides  to  take  a  chance  and  make  no  effort  to  recoup 
itself  for  the  investment  out  of  earnings,  it  stands  a 
considerable  chance  of  losing  most  of  its  capital. 
Under  these  conditions,  a  limited  term  franchise  is 
most  undesirable,  from  the  standpoint  both  of  the 
grantor  and  of  the  grantee,  and  this  fact  should  be 
taken  into  consideration  as  a  major  element  in  the 
determination  of  the  value  of  the  unexpired  term  of  the 
franchise  in  a  condemnation  proceeding.  It  has  been 
customary  for  Professor  Bemis,  Bion  J.  Arnold,  and 
others,  in  estimating  the  value  of  the  unexpired  life 
of  a  limited  term  franchise,  to  base  it  upon  the  expected 
net  earnings  of  the  utiHty  during  the  franchise  period, 
over  and  above  a  minimum  fair  return  upon  the  invest- 
ment. This  method  I  believe  to  be  unsound  and  highly 
detrimental  to  the  public  interest.  When  a  company 
accepts  a  limited  term  franchise  with  a  fixed  rate,  it 
should  be  presumed  that  the  grantees  intend  to  get 
their  money  back  out  of  earnings,  and  accordingly, 
when  we  come  to  value  the  franchise  as  a  separate 
and  distinct  element,  we  should  not  fail  to  take  notice 
of  the  fact  that  the  utiHty  not  only  must  earn  a  fair 
return  from  year  to  year  upon  the  amount  of  the 
investment,  but  also  ought  to  lay  aside  a  surplus 
sufficient  to  amortize  the  difference  between  the  cost 
of  the  property  and  its  prospective  scrap  value  when 
its  franchise  or  life  expires.  If  we  allow  the  physical 
property  at  its  full  going  value,  then  the  value  of  the 
franchise  should  be  greatly  reduced  by  the  elimination 
of  the  amortization  charges  upon  the  investment  from 
the  net  earnings.  If,  on  the  other  hand,  we  allow  the 
franchise  at  its  full  value  on  the  basis  of  its  earning 
power  in  excess  of  a  fair  return  upon  the  investment 
without  amortization  charges,   we  should  figure  the 


FRANCHISE      VALUES 


65 


present  value  of  the  physical  property  in  the  light  of  the 
fact  that  it  will  have  only  scrap  value  at  the  expiration 
of  the  grant.  This  suggestion  is  somewhat  revolution- 
ary and  I  admit  that  no  absolutely  true  method  can 
be  fixed  with  certainty.  Probably  the  fair  valuation 
would  be  derived  by  a  method  half  way  between  the 
usual  one  and  the  one  just  suggested.  This  half-way 
method  would  be  justified  by  the  fact  that  in  practice 
public  utilities  do  have  a  good  chance  of  preserving 
their  physical  investment  at  the  expiration  of  the 
franchise,  either  through  the  renewal  of  the  grant  or 
through  the  sale  of  the  property.  At  the  same  time 
they  stand  a  good  chance  of  losing  their  physical 
property.  The  danger  of  total  loss  is  more  technical 
and  legal  than  it  is  real,  but  in  valuing  a  company's 
franchise,  in  a  case  where  it  is  being  acquired  to  meet 
a  public  necessity,  the  technical  and  legal  considera- 
tions chiefly  determine  what  the  company  is  entitled 
to  get  when  it  is  deprived  of  its  street  rights. 

Another  element  that  goes  to  determine  the  value  of 
a  franchise  in  condemnation  proceedings  is  the  exclu- 
siveness  or  non-exclusiveness  of  the  grant.  In  the 
Long  Island  Water  Supply  case,  the  New  York  courts 
held  that  although  the  franchise  was  exclusive,  its 
exclusiveness  could  be  taken  away  at  any  time  by  a 
legislative  repeal  and,  therefore,  that  the  feature  of 
exclusiveness  added  nothing  to  the  separate  and  dis- 
tinct value  of  the  franchise  for  which  the  city  was 
bound  to  pay.  This  is  undoubtedly  good  law  where 
the  exclusiveness  of  the  franchise  is  merely  a  matter 
of  legislation,  not  a  matter  of  contract.  Where  it  is 
a  matter  of  contract,  if  the  rates  are  not  subject  to 
reduction,  exclusiveness  will  certainly  enhance  the 
value  of  the  franchise  in  condemnation  proceedings. 

4.  FRANCHISE   VALUES   FOR   INVOLUNTARY 

SALE 

By  "involuntary  sale"  I  mean  sale  enforced  in  ac- 
cordance with  the  terms  of  a  franchise  or  contract  at 
the  option  of  the  city.  For  example,  the  old  Denver 
water  franchise  gave  the  city  the  right  to  purchase  the 
company's  plant  at  the  expiration  of  the  franchise  at 
a  valuation  to  be  fixed  in  a  specified  manner,  but  im- 
posed no  obligation  upon  the  city  either  to  purchase 
the  plant  or  to  renew  the  franchise.  On  the  other  hand, 
under  the  old  exclusive  Minneapolis  gas  franchise,  the 
city  had  the  right  to  purchase  the  franchise  and  works 
at  their  actual  value  at  the  end  of  forty  years,  with 
the  proviso  that  if  the  city  did  not  exercise  its  option, 
the  franchise  would  be  automatically  extended  for  an 
additional  period  of  twenty  years.  In  both  these  cases, 
and  in  others  more  or  less  similar  to  them,  including 
cases  of  the  Wisconsin  indeterminate  permit  type,  pur- 
chases  by   the   city   might   properly   be   regarded   as 


involuntary  from  the  standpoint  of  the  franchise- 
holder.  Clearly,  in  the  Denver  case  the  franchise 
could  not  have  been  given  any  value  in  case  the  city 
had  elected  to  purchase  the  plant  at  the  expiration  of 
the  grant;  and  just  as  clearly,  Minneapolis  would  have 
had  to  pay  a  good  round  sum  for  the  gas  franchise  if 
the  city  had  elected  to  take  over  the  plant  in  1910. 
Under  the  Wisconsin  law,  it  has  been  determined  that 
nothing  need  be  paid  for  the  franchise  as  such  when  a 
city  exercises  its  option  to  acquire  a  public  utility. 
But  in  the  Wisconsin  cases,  the  fair  price  is  fixed  by 
the  state  commission  and,  in  practice,  includes  an 
allowance  for  development  expenses  and  early  losses 
which  under  a  different  type  of  franchise  might  readily 
be  classed  as  franchise  value. 

In  the  celebrated  Bristol  water  works  case,  the  Rhode 
Island  courts  approved  a  franchise  valuation  which  was 
in  excess  of  the  value  of  the  physical  property,  even 
though  the  franchise  contained  a  clause  authorizing 
the  municipality  at  its  own  option  to  terminate  the 
grant.  The  franchise  was  an  exclusive  one  for  a  period 
of  fifty  years,  subject  to  this  right  of  termination,  and 
the  court  held  that  in  case  of  termination,  even  under 
the  option  reserved  for  that  purpose,  the  company  was 
entitled  to  receive  the  full  value  of  the  franchise  as  an 
exclusive  grant  for  the  entire  period.  This  decision 
appears  to  have  been  grossly  unjust  to  the  public  and 
ought  not  to  be  a  determining  factor  in  the  fixing  of 
the  law  of  franchise  valuations. 

It  is  not  unusual  to  find  in  the  purchase  clause  of  a 
franchise  a  provision  that,  if  the  property  is  taken  over 
by  the  city,  it  shall  be  taken  over  at  its  fair  and  reason- 
able value  without  taking  into  consideration  the  value 
of  the  franchise  itself.  In  such  cases,  the  subject- 
matter  of  this  discussion,  nominally  at  least,  is  elim- 
inated. However,  unless  the  language  used  is  very 
precise  and  very  comprehensive,  the  grantee  is  certain 
to  try  to  get  what  would  otherwise  be  a  franchise  value 
under  the  guise  of  something  else. 

Public  utility  property,  especially  in  its  intangible 
elements,  is  Protean.  Having  dismissed  it  in  one  guise, 
we  are  likely  to  find  it  coming  back  in  another;  or  even 
more  strangely,  if  we  accept  and  embrace  it  in  one 
guise,  it  is  likely  straightway  to  renew  its  advances  in 
another.  One  public  service  corporation  attorney  said 
to  me,  in  the  midst  of  a  negotiation,  that,  when  he 
considered  all  the  perils  to  which  a  utility  investment 
is  subject  and  all  of  the  elements  of  value  that  can 
properly  be  claimed  for  it,  he  sometimes  had  diflBculty 
in  imagining  how  any  public  utility,  under  any  condi- 
tions, could  possibly  earn  a  fair  return.  It  is  of  the 
utmost  importance  to  the  public,  when  the  franchise  is 
definitely  excluded  from  the  valuation  by  the  terms  of 
the  contract,  that  this  provision  should  not  be  rendered 


66 


THE      UTILITIES      MAGAZINE 


nugatory  by  the  admission  of  substitutes.  It  is  also 
of  the  utmost  importance  that,  irrespective  of  any  such 
provision  in  the  contract,  the  value  of  the  franchise 
should  not  be  duplicated  or  triplicated  in  going  value, 
good  will,  water  rights  or  other  intangible  elements 
often  claimed  by  the  companies. 

It  is  apparent  that  the  principles  of  valuation  as  to 
franchises  in  these  cases  of  involuntary  sale  differ  from 
the  principles  of  valuation  in  condemnation  cases  by 
reason  of  the  restrictions  contained  in  the  purchase 
clause  of  the  franchise  itseK  and  also  by  reason  of  the 
occasion  of  the  purchase.  Condemnation  may  take 
place  at  any  time.  Involuntary  sale  as  here  defined  is 
likely  to  come  at  the  expiration  of  the  franchise  as  an 
alternative  to  its  renewal.  Moreover,  there  is  a  cer- 
tain difference  in  the  spirit  of  the  proceedings.  Where 
the  franchise  holder  has  agreed  that  the  property  may 
be  taken  over,  even  though  this  agreement  may  have 
been  extorted  from  him  as  a  part  of  the  price  of  his 
seciu'ing  any  franchise  at  all,  he  is  not  entitled  to  any 
additional  allowance  on  the  ground  that  the  property 
is  being  taken  away  from  him  against  his  will.  He  has 
made  his  bed:  now  he  must  lie  on  it.  In  most  cases 
of  this  kind  no  value  at  all  can  be  assigned  to  the 
franchise  as  a  separate  item. 

5.  FRANCfflSE  VALUES  FOR  THE  PURPOSE  OF 
VOLUNTARY  PURCHASE 

In  voluntary  negotiations  for  the  purchase  of  a 
public  utility  property,  it  is  impossible  to  lay  down 
specific  rules  for  valuation.  Everything  depends  upon 
the  relative  positions  of  the  two  parties  to  the  bargain. 
The  company,  naturally,  will  not  be  disposed  to  sell 
the  property  for  less  than  its  value  to  itself.  On  the 
other  hand,  the  city,  if  it  acts  on  business  principles, 
will  not  be  disposed  to  pay  more  than  the  property  will 
be  worth  for  municipal  purposes.  The  valuation  is  a 
matter  of  bargaining.  While  it  might  be  shown  by  a 
more  or  less  orthodox  method  that  the  franchise  has 
great  value,  the  city  will  not  be  disposed  to  pay  this 
assumed  value  unless  the  city  needs  the  franchise.  If 
the  city  already  has  the  right  to  duplicate  the  plant,  it 
would  act  foolishly  and  in  an  unbusinesslike  manner 
if  it  agreed  to  pay  a  large  sum  for  the  company's 
franchises,  unless,  indeed,  the  city  was  in  fear  of  com- 
petition from  the  company  and  was  guided  by  the  same 
motives  which  have  so  often  controlled  public  service 
corporations  in  swallowing  up  their  rivals.  As  a 
matter  of  fact,  however,  a  city  seldom  has  reason  to 
fear  the  competition  of  a  private  company.  The  fear 
is  all  on  the  other  side. 

In  voluntary  negotiations  for  purchase,  the  city 
might  be  foolish  to  pay  even  the  original  cost  of  the 
property,  or  the  present  value  based  upon  reproduction- 


cost-less-depreciation,  or,  on  the  other  hand,  it  might 
be  wise  to  pay  a  sum  greatly  in  excess  of  the  cost  of 
duplication,  if  by  doing  so  it  could  get  a  profitable 
business  more  cheaply  than  in  any  other  way. 

The  valuation  of  the  franchise  for  voluntary  pur- 
chase is  likely  to  appear  with  increasing  frequency  in  ne- 
gotiations for  the  renewal  and  resettlement  upon  a  new 
basis  of  franchise  rights  already  outstanding.  The 
value  of  the  unexpired  franchise  in  negotiations  of  this 
sort  has  been  recognized  in  the  celebrated  street  rail- 
way settlements  of  Chicago,  Cleveland  and  Kansas 
City.  These  were  not  actual  pm-chase  cases,  but  cases 
in  which  the  determination  of  the  price  at  which  the 
city  could  take  over  the  property,  if  it  desired  to  do  so, 
was  regarded  as  a  primary  consideration.  Incidentally, 
the  valuation  agreed  upon  was  used  as  a  basis  for  fixing 
the  recognized  investment  and  determining  either  rates 
or  profit  sharing  in  the  future.  In  agreements  of  this 
sort,  it  may  be  necessary,  under  the  local  conditions 
peculiar  to  any  particular  case,  to  give  a  value  to  the 
franchise  and  include  it  not  only  in  the  general  piu-chase 
price,  but  in  the  recognized  capital  upon  which  rates 
and  profits  are  to  be  reckoned.  Nevertheless,  the  in- 
clusion of  the  estimated  value  of  old  unexpired  rights 
in  this  way  is  not  to  be  accepted  unless  absolutely 
necessary.  The  theory  of  the  inclusion  of  the  franchise 
value  in  these  cases  is  that  the  city,  in  order  to  get 
lower  rates  or  better  service,  agrees  to  commute  and 
capitalize  the  company's  prospective  earnings  during 
the  unexpired  period  of  the  old  franchise  on  the  basis 
of  the  old  rates  and  the  old  service  obligations.  This 
is  much  like  funding  debts  incurred  for  the  payment  of 
operating  expenses  of  the  city  government. 

The  Kansas  City  negotiations  in  1914  presented  a 
curious  case,  where  the  street  railway  had  gone  into 
the  hands  of  receivers  and  a  new  franchise  was  asked 
for  on  the  ground  that  the  terms  of  the  old  franchise 
could  not  be  compHed  with  if  the  road  was  to  escape 
from  bankruptcy.  At  the  same  time,  in  the  valuation 
for  a  resettlement  the  company  claimed  an  allowance 
of  some  $13,000,000  as  the  value  of  the  unexpired  term 
of  the  franchise  which  it  was  trying  to  get  rid  of.  And 
in  th's  case  the  city  "fell  for  it"  with  certain  glosses 
and  concealments.  New  York  City  did  likewise  in  a 
more  roundabout  way  when  it  guaranteed  the  rapid 
transit  companies'  existing  profits  as  the  price  of  secur- 
ing their  co-operation  in  subway  and  elevated  railroad 
expansion. 

6.  FRANCHISE  VALUES  FORjTHE  PURPOSE  OF 
CAPITALIZATION 

It  is  a  not  unusual  provision  of  public  service  laws 
which  confer  upon  regulating  bodies  the  right  to  control 
the  stock  and  bond  issues  of  public  service  corporations, 


FRANCHISE      VALUES 


67 


that  no  franchise  shall  be  capitalized  except  to  the 
extent  of  the  necessary  original  cost  to  the  grantees  in 
the  shape  of  lump  sum  payments  to  the  public  authori- 
ties which  made  the  grant.  Under  provisions  of  this 
kind  it  is  immaterial  how  much  the  present  owners  of 
the  franchise  may  have  paid  to  others  for  it.  It  is 
also  immaterial  how  much  the  grantees  may  be  required 
to  pay  to  the  city  in  the  form  of  annual  rentals  or  special 
taxes  or  license  fees.^These  expenditures  are  to  be 
treated  as  operating  expenses  and  not  capitalized.  The 
only  element  of  franchise  value  to  be  admitted  to  cap- 
italization is  the  actual  original  investment  required  for 
the  acquisition  of  the  franchise  from  the  city. 

The  laws  have  not  always  been  so  strict.  In  1884, 
when  the  rival  gas  companies  of  New  York  City,  after 
a  period  of  cut-throat  competition,  following  a  long 
period  of  large  dividends,  desired  to  consolidate,  the 
legislature  was  accommodating  enough  to  authorize 
them  to  do  so,  and  to  allow  them  to  fix  upon  the  value 
of  their  property  and  franchises  and  to  issue  securities 
not  in  excess  of  such  value.  Curiously  enough,  the 
companies  found  their  franchises  were  worth  exactly 
$7,781,000  and  capitahzed  them  accordingly. 

That  franchises  should  be  capitalized  except  as  to 
the  necessary  original  cost  of  acquiring  them  is  con- 
trary to  public  policy,  and  therefore  I  need  not  discuss 
further  the  principles  of  valuation  as  to  franchises  for 
the  purpose  of  capitalization. 

A  word  should  be  said  bearing  upon  the  valuation  of 
fag-end  franchises.  It  sometimes  happens  that  street 
railway  routes  are  broken  up  through  the  expiration  of 
the  franchises  for  different  portions  of  the  same  route 
at  different   times.     This   is   notoriously   the   case  in 


Detroit  today.  The  principal  franchises  in  the  heart 
of  the  city  have  expired,  while  the  Detroit  United 
Railway  still  maintains  its  hold  upon  the  extremities 
of  the  routes  by  reason  of  franchises  received  from  the 
local  authorities  of  towns  and  villages  which  were  later 
annexed  to  the  city.  The  city  cannot  establish  a 
complete  and  satisfactory  municipal  system  without 
the  use  of  these  outlying  ends,  and  the  company  cannot 
operate  profitably  at  all  without  the  use  of  the  streets 
where  its  franchises  have  expired.  Each  party  is  in  a 
position  to  hold  the  other  up  with  more  or  less  success, 
but  without  profit  to  itself.  In  public  relations  fran- 
chises should  never  be  given  a  "hold-up"  value.  The 
valuation  of  fag-end  franchises  should  be  made  on  the 
basis  of  their  value  to  the  owner  as  complete  independ- 
ent operating  rights.  If  they  have  no  value  except  in 
connection  with  other  rights  which  do  not  exist,  no 
value  should  be  assigned. 

Franchises  sometimes  contain  special  provisions  and 
conditions  which  add  to  or  detract  from  their  value. 
The  experience  of  Detroit  may  be  cited  again,  where  a 
provision  of  the  famous  Pingree  grant  to  the  effect 
that  any  new  street  railway  routes  required  for  the 
convenience  of  the  public  shall  first  be  offered  to  the 
grantees  of  this  franchise,  has  returned  to  plague  the 
city  in  its  efforts  to  establish  municipal  ownership  on 
the  five-cent  lines  before  the  expiration  of  the  Pingree 
grant  on  the  low-fare  lines.  Special  provisions  of  this 
sort  naturally  have  to  be  taken  into  consideration  in 
the  valuation  of  franchises,  but  their  effect  is  so  prob- 
lematical and  they  are  sometimes  so  contrary  to  public 
policy  that  they  should  not  be  permitted  to  swell  to  an 
appreciable  degree  the  value  placed  upon  a  franchise 
for  public  purposes. 


DETERMINING  FRANCHISE  VALUES 


Henry  deForrest  Baldwin 

President  and  Counsel  of  the  Queen  County  Water  Company,  New  York  City 

WITH  most  of  Mr.  Wilcox's  observations  I  am 
in  hearty  accord.  But  I  have  tried  very 
hard,  without  success,  to  understand  his 
proposition,  so  confidently  asserted,  that  the  reduction 
of  the  rates  of  a  public  service  corporation  by  public 
authority  gives  a  security  and  stabihty  to  the  property 
and  to  its  earning  power  which  enhances  the  value  of 
the  franchise;  and  that,  for  taxing  purposes,  a  franchise 
under  which  high  rates  are  charged  is  to  be  valued  the 
more  highly  the  more  likely  it  is  to  have  its  rates  re- 
duced by  public  authority. 


Of  course,  it  is  obvious  that  the  greater  the  security 
of  the  investment  the  lower  the  ratio  of  return  to  the 
capitalized  value  of  the  enterprise,  including  the  fran- 
chise. But  greater  security  does  not  come  from  a 
reduction  of  rates.  Security  comes  primarily  from  the 
prevailing  morality  in  the  community  in  which  the 
franchise  is  operated  being  on  a  high  plane,  and  second- 
arily from  institutions  which  ensure  a  judicial  and  fair 
consideration  of  the  rights  of  the  grantees  of  franchises 
and  an  effective  enforcement  of  those  rights  against 
local  clamor. 


68 


THE      UTILITIES      MAGAZINE 


Mr.  Wilcox  points  out  the  diflFerent  ways  courts  look 
upon  franchise  values,  according  to  the  purpose  for 
which  the  valuation  is  made. 

The  totally  different  methods  which  prevail  in  valu- 
ing franchises  for  taxation  and  in  valuing  them  for  rate 
making  and  condemnation  show  how  much  has  yet  to 
be  done  before  such  appraisals  are  placed  upon  a  sound 
basis. 

Some  of  the  methods  sought  to  be  applied,  particu- 
larly in  cases  where  the  appraisal  is  made  to  tax  fran- 
chises, are  methods  which  have  been  rejected  in  the 
valuation  of  other  kinds  of  property.  For  instance, 
when  a  piece  of  property,  held  under  a  long-term  lease, 
is  condemned,  and  it  becomes  necessary  to  divide  the 
award  between  the  owner  of  the  fee  and  the  owner  of 
the  leasehold,  it  is  not  permissible  to  add  together  the 
value  of  the  respective  interests  of  these  two  parties. 
The  first  inquiry  must  be  What  is  the  value  of  the 
entire  property?  and  then  the  various  interests  must 
be  carved  out  of  that  value.  Perhaps,  theoretically, 
the  other  method  would  produce,  the  same  result,  but 
in  practice  it  does  not  do  so.  So,  in  valuing  franchises, 
we  should  first  value  the  entire  enterprise,  franchise 
included,  and  then  carve  out  of  that  value  the  proper 
portion  to  be  attributed  to  the  mere  permission  to  use 
the  public  streets  in  carrying  on  the  business.  This 
method  would  defeat  many  assessments  for  taxation. 

Separately  from  a  going  enterprise  a  franchise  has 
little  or  no  market  value,  except  under  very  peculiar 
circumstances.  When  granted  it  is  usually  worth 
nothing,  because  the  terms  imposed  equal  the  opportu- 
nities to  utilize  it  for  profit.  Where  it  is  worth  some- 
thing at  the  time  it  is  granted,  that  value  can  be  easily 
computed.  Difficulties  arise  in  valuing  a  franchise 
only  when  it  is  sought  to  attribute  to  it — that  is,  to  the 
permission  to  use  the  streets — the  increment  in  value 
which  comes  to  the  entire  enterprise  after  it  is  developed 
and  is  proved  to  be  a  commercial  success  under  the 
original  conditions  imposed.  The  city  authorities  in 
taxing  it  seek  to  attribute  the  entire  increment  to  the 
franchise;  and  when  it  comes  to  rate  making,  they  seek 
to  disregard,  as  far  as  possible,  all  of  such  increment, 
and  hold  the  franchise  itself  as  worthless. 

We  may  expect  to  find  the  best  reasoned  decisions  in 
rate  cases.  Courts  are  notoriously  indisposed  to  inter- 
fere with  the  judgment  of  tax  assessors,  and  in  condem- 
nation cases  the  award  usually  contains  an  item  by 
way  of  good  measure  to  include  any  element  which  the 
court  may  conclude  should  have  been  recognized. 

In  appraising  the  value  of  a  public  service  enterprise 
for  rate  making  it  is  not  at  all  its  market  value  that  is 
inquired  into;  it  is  the  value  upon  which  the  owners  are 
entitled  to  earn  a  fair  rate  of  return. 

I  desire  to  urge  here  that  it  is  this  value — ^namely, 


that  upon  which  the  owners  and  operators  are  entitled 
to  earn  a  fair  rate  of  return — which  should  be  the 
standard  out  of  which  should  be  carved  the  value  of 
the  franchise;  and  that  valuations  for  all  other  purposes 
should  be  such  modifications  of  this  as  are  made  neces- 
sary in  order  to  accomplish  a  just  result. 

Net  earnings  are  undoubtedly  an  important  factor  in 
the  valuation  of  franchises  for  any  purpose,  but  to 
apply  what  is  called  "the  net  earnings  rule"  differently 
in  a  tax  case  from  the  way  it  would  be  applied  in  a  rate 
making  case  or  a  condemnation  case  is  sheer  oppression. 
The  way  the  New  York  courts  have  applied  it  results 
in  turning  into  the  state  as  the  tax  on  the  special 
franchise  about  one  third  of  what  remains  of  the  gross 
earnings  after  deducting  operating  expenses,  deprecia- 
tion, taxes  and  6  per  cent  upon  the  value  of  all  the 
physical  property,  used  and  useful,  rendering  the  serv- 
ice. No  other  property  is  appraised  for  taxation  in 
any  such  way.  If  this  method  were  used  in  a  rate  case, 
it  would  result  in  an  absurdity,  as  Mr.  Wilcox  has 
pointed  out,  and  if  used  in  a  condemnation  case,  it 
would  often  lead  to  a  scandal. 

The  vice  in  this  method  is  due  to  a  double  error: 
first,  in  attributing  all  of  the  value  of  the  enterprise, 
other  than  the  value  of  the  tangible  property,  to  the 
franchise,  and,  secondly,  to  capitalizing  that  part  of 
the  net  earnings  thus  attributed  to  the  franchise  at  a 
very  low  percentage,  as  though  the  value  of  the  fran- 
chise thus  arrived  at  was  almost  as  permanent  and 
secure  as  a  real-estate  mortgage. 

With  respect  to  all  kinds  of  property,  other  than 
franchises,  the  valuation  for  taxation  is  made  on  a  more 
conservative  basis  than  for  any  other  purpose.  To 
treat  franchises  differently  is  dishonest  and  prejudicial 
to  a  proper  development  of  our  taxing  system.  If  it 
be  the  policy  of  the  state  to  take  one  third  of  the  net 
receipts  of  a  public  service  corporation,  after  allowing  a 
bare  6  per  cent  out  of  net  earnings  upon  a  conservative 
valuation  of  the  tangible  assets,  it  would  be  better  for 
the  morals  of  the  community  to  take  such  a  position 
directly  and  not  reach  that  result  by  false  reasoning. 

The  current  ideas  of  the  value  of  franchises  are 
exaggerated.  This  is  due  to  the  peculiar  conditions 
which  have  existed  in  this  country.  Our  government 
was  too  inefficient  satisfactorily  to  deal  directly  with 
the  numerous  public  services  which  became  more  and 
more  necessary  as  we  came  to  live  in  crowded  commu- 
nities. Then,  we  inherited  political  traditions  against 
the  extension  of  governmental  functions. 

The  public  demanded  those  public  services:  the 
government  was  not  equipped  to  supply  them:  we  did 
not  wish  the  government  to  supply  them :  so  franchises 
had  to  be  granted  to  private  parties.     But  the  notions 


FRANCHISE      VALUES 


69 


as  to  the  control  of  the  grantees  for  the  public  good 
were  crude  and  improvident. 

The  interest  of  the  state  and  the  people,  under  our 
political  conditions,  has  been  too  often  treated  as  merely 
the  interest  of  a  few  politicians  in  office  for  a  short  time. 
The  kind  of  men,  who  look  favorably  on  propositions 
to  pay  running  expenses  out  of  borrowed  money  and  to 
collect  revenues  from  the  sources  which  can  pay  this 
year's  taxes  with  the  least  organized  opposition,  are 
not  given  to  careful  scrunity  of  the  public  interest  when 
a  contractor  undertakes  to  supply  a  needed  public 
service.  They  realize  that  the  conditions  which  they 
impose  are  not  likely  to  be  criticised  by  the  public 
until  their  results  are  proved  to  be  unfortunate.  By 
that  time  a  new  set  of  statesmen  will  be  in  charge.  We 
need  not  be  surprised  at  the  absence  of  a  far-sighted 
policy  on  the  part  of  our  public  officials. 

And  the  promoters  who  accepted  such  grants,  for 
the  most  part,  have  had  no  intention  of  staying  in  the 
enterprises  and  completing  the  contracts.  And  the 
investing  public,  equally  with  the  promoters  and  poli- 
ticians, have  been  short-sighted.  They,  too,  make 
investments  to  sell  out  at  a  profit — not  to  stay  in  and 
reap  the  legitimate  reward  of  a  well-conceived  and  well- 
developed  enterprise.  Fortunes  made  through  public 
franchises  are,  to  a  great  extent,  made  by  trading  in 
hopes — propositions  capitalized  by  those  given  to 
happy  optimism  and  sold  out  in  small  lots  to  a  credu- 
lous public  given  to  gambling  and  watchful  of  the  daily 
market  quotations. 

The  real  public,  who  pay  in  the  end  for  all  the  mis- 
takes, are  hard  to  distinguish.  They  are  not  a  per- 
manent public.  They  are  nomadic.  They  move 
about,  and  no  individual  knows  how  long  he  is  likely 
to  have  a  stake  in  any  particular  community. 

The  result  of  all  these  conditions  has  naturally 
resulted  in  a  management  of  public  service  utilities 
unsatisfactory  both  to  the  public  and  to  the  investors. 
The  promoter  and  those  who  first  exploit  a  franchise 
try  to  get  out  of  it  all  that  is  possible,  regardless  of  the 
future,  in  order  to  boom  the  stock  and  unload  on  others. 
Everything  possible  is  charged  to  capital  account;  no 
provision  is  made  for  depreciation,  and  the  biggest 
possible  dividends  are  paid.  It  is  plausibly  claimed 
that  the  great  element  of  value  in  the  enterprise  is  the 
franchise. 

The  people  on  whom  these  enterprises  have  been 
unloaded  have  often  had  occasion  to  pay  heavily  for 
their  faith  in  the  popular  idea  respecting  franchise 
values. 

It  is  not  surprising  that  such  unfortunate  conditions 
have  resulted  in  confusion  of  thought  as  to  franchise 
values. 

In  view  of  the  way  in  which  franchises  have  been 


granted  and  exploited,  the  attempt  to  tax  them  is  not 
to  be  wondered  at.  The  public  believe  in  vicarious 
punishment,  and  if  one  corporation  offends,  it  is  ready 
to  visit  the  penalty  on  any  other  corporation  which 
happens  to  be  within  convenient  reach.  It  is  the 
natural  thing  to  try  to  correct  one  evil  by  another, — 
to  take  back  part  of  an  improvident  grant  through 
taxation.  Victor  Hugo  somewhere  said:  "The  Lord 
made  a  mouse;  and  he  said,  'That  is  a  mistake;  I  shall 
make  a  cat.'  "  Even  though,  in  the  long  run,  a  tax 
on  a  public  service  corporation  bears  upon  the  great 
mass  of  the  people,  it  is  a  popular  tax,  and  is  in  response 
to  a  real  sense  of  justice,  expressed  in  a  desire  to  punish 
one  of  a  class  looked  upon  as  wrongdoers  and  to  make 
it  contribute  a  part  of  the  tolls  wrung  from  the  public 
through  what  is  believed  to  be  an  unreasonable  ex- 
action. 

It  is  the  ignorance  of  the  people  which  leads  them 
to  immoral  and  unfair  conduct  toward  the  holders  of 
public  franchises. 

My  late  senior  partner,  Mr.  Lord,  used  to  say  that 
resisting  unjust  taxation  has  led  to  all  progress  in  civil 
liberty.  I  am  tempted  to  add  that  it  materially  assists 
a  correct  understanding  of  values  and  correct  business 
methods. 

Attempts  to  value  franchises  in  condemnation  cases 
proceeded  without  much  regard  to  any  principle.  It 
was  only  after  the  state  began  to  tax  franchise  values 
that  a  careful  study  was  made  of  what  those  values 
consisted. 

The  Tax  Law  in  the  State  of  New  York  provides  that 
all  real  property  and  all  personal  property  shall  be 
taxed.  Notice  that  it  does  not  provide  that  all  prop- 
erty shall  be  taxed.  Prior  to  1899  the  tangible  prop- 
erty of  public  service  corporations  was  assessed  for 
taxation.  The  value  was  calculated  on  as  conserva- 
tive a  basis  as  possible,  and  often  omitted  interest  dur- 
ing construction  and  other  allowances.  The  market 
value  of  a  company's  stocks  and  bonds  usually  showed 
an  aggregate  value  for  the  enterprise  very  much  more 
than  the  appraisals  of  the  land  and  personal  property. 
The  difference  between  these  amounts  was  cheerfully 
claimed  by  the  corporation  to  be  the  value  of  the 
franchise,  as  the  courts  had  held  that  the  franchise  was 
not  taxable,  being  neither  real  property  nor  personal 
property.  This  encouraged  an  exaggerated  view  on 
the  part  of  the  community  of  the  value  of  franchises. 

In  1899  the  legislature  in  New  York  thought  that  it 
had  discovered  a  new  source  of  revenue,  and  proceeded 
to  tax  franchises.  It  did  not  propose  to  tax  all  busi- 
ness or  all  property,  but  only  a  single  element  of  a 
particular  kind  of  business.  And  the  legislature  was 
justified,  from  court  decisions  and  the  popular  view,  in 


70 


THE      UTILITIES      MAGAZINE 


believing  that  the  value  of  franchises — that  is,  the 
value  of  the  mere  privilege  of  maintaining  structures 
and  equipment  in  and  under  the  public  streets — was 
worth  immense  amounts  of  money. 

As  might  be  expected,  the  tax  assessors  attributed  all 
value  in  public  service  enterprises,  other  than  tangible 
property,  to  the  franchises.  And  the  court  often  sur- 
passed this  when  it  adopted  the  net  earnings  rule, 
which  capitalized  at -a  low  percentage  the  net  earnings, 
after  deducting  6  per  cent  of  the  present  value  of  the 
tangible  property. 

This  is  like  the  claim  on  behalf  of  the  lessee  of  a 
building,  when  the  building  was  under  condemnation, 
that  the  profits  of  his  business  were  the  measure  of  the 
value  of  his  lease.  Surely  the  fact  that  a  saloon  keeper 
can  make  a  profit  in  running  a  saloon  on  a  particular 
corner  has  a  bearing  on  the  value  of  the  lease.  But 
there  are  other  factors  of  value  in  such  an  enterprise 
beyond  the  lease  and  the  bar  equipment,  and  it  has 
been  held  that  the  saloon  keeper's  profits  do  not  meas- 
ure the  value  of  his  lease.  Yet,  when  it  came  to  valu- 
ing franchises  for  taxation,  the  temporary  earnings  have 
been  used  as  the  measure  of  that  value. 

In  tax  cases  the  New  York  courts  have  declined  thus 
far  to  recognize  the  necessary  Investments  of  the  com- 
pany in  building  up  its  business  by  expending  money 
for  talent  and  for  experiments  and  for  the  deficits  in 
return  on  moneys  actually  invested  during  long  periods 
of  development.  But  they  have  recently  in  a  rate 
case  recognized  deficits  in  past  earnings  under  the 
term  "going  value." 

Having  made  the  original  error  of  attributing  to  the 
franchise  all  of  the  earnings  beyond  what  can  be 
definitely  attributed  to  some  other  element  of  value, 
going  value  is  likely  to  assume  more  and  more  impor- 
tance as  we  struggle  to  arrive  at  a  correct  basis  for  the 
valuation  of  franchises  for  taxation.  Our  best  hope  is 
that  as  knowledge  increases  the  elements  included  in 
going  value  may  be  increased  and  the  exaggerated  view 
of  franchise  values  modified. 

Of  course,  when  we  attribute  going  value  to  a  public 
service  enterprise,  we  must  assume  that  it  is  well 
adapted  to  render  a  public  service  that  is  needed  by  the 
community,  and  that  it  is  worth  to  the  community  what 
it  has  cost  the  investors,  even  though  it  may  have 
been  unremunerative  up  to  the  time  with  reference  to 
which  the  inquiry  is  directed.  The  enterprise  must  be 
one  that  if  it  could  be  carried  on,  unregulated,  as  a 
purely  commercial  proposition,  would  eventually  pay, 
and  it  must  be  one  of  such  benefit  to  the  community  as 
to  entitle  the  investors  to  fair  remuneration.  If  we 
include  all  the  considerations  affecting  the  rights  of  the 
owners  to  remuneration  in  appraising  going  value,  we 


shall  do  no  more  than  estimate  as  of  the  present  time 
the  fair  claims  against  the  enterprise. 

Now,  is  the  going  value  to  be  limited  to  the  actual 
cost,  the  out-of-pocket  losses  of  the  investors?  Or 
should  it  also  include  the  loss  of  return  on  the  money 
invested  during  the  unremunerative  periods?  Or 
should  it  also  include,  in  addition  to  losses  and  loss  of 
return,  a  fair  allowance  for  the  foresight  exhibited,  the 
energy  displayed,  and  the  risks  incurred,  even  after 
the  risks  have  become  a  thing  of  the  past? 

Every  enterprise  has  some  risk  involved  in  it.  Its 
value  is  more  or  less  doubtful  until  it  develops  and  until 
the  event  proves  that  it  is  sound.  Value  is  relative  as 
to  time  and  place;  and  what  is  valueless  under  one 
management  may  become  a  great  success  under  another 
management.  Wliy  should  we  attribute  to  one  feature 
of  a  contract — the  bare  permission  given  to  the  inves- 
tors to  use  the  streets — the  enhancement  in  value  which 
comes  through  successful  development  and  operation? 
Might  it  not  with  more  correctness  be  attributed  to 
the  services  of  the  skilful  manager,  whose  intelligence 
led  to  its  success,  perhaps  after  some  blunderer  had 
run  it  into  the  ground,  or  to  the  credit  and  optimism 
of  the  financial  backers?  The  enterprise  which  uses 
the  streets  is  not  different  in  this  respect  from  any 
other  business  venture. 

Franchises  are  government  contracts,  and  their 
value,  like  a  government  bond,  depends  on  the  public 
faith.  The  local  government  is  usually  in  a  position 
to  prevent  the  success  of  any  public  service  enterprise. 
In  the  usual  case  the  terms  of  the  contract  can  be  al- 
tered by  the  party  of  the  first  part,  the  grantor,  from 
time  to  time,  since  an  express  or  implied  term  of  most 
franchises  requires  that  the  service  shall  be  subject  to 
public  regulation  and  rendered  at  a  reasonable  rate. 
When  we  undertake  to  attribute  value  to  such  a  fran- 
chise, it  is  not  like  attributing  a  value  to  an  ordinary 
contract,  where  the  terms  are  fixed.  If  the  rate  charged 
gives  the  investors  no  more  than  a  reasonable  return  in 
view  of  the  risk  involved,  the  permission  to  engage  in 
the  enterprise  cannot  be  worth  anything.  If  the  in- 
vestors charge  more  than  a  reasonable  return,  they 
are  violating  their  contract,  and  should  be  compelled 
to  live  up  to  it  and  reduce  the  rate  to  what  is  reason- 
able. From  this  point  of  view,  where  a  franchise,  as 
such,  is  deemed  to  have  a  distinct  value,  such  value  is 
the  capitalization  of  the  extent  to  which  the  managers 
of  the  public  service  enterprise  are  permitted  to  go 
beyond  the  conditions  of  the  contract  in  the  matter  of 
rates  and  service,  through  the  supineness  or  inefiiciency 
of  the  public  authorities  charged  with  the  regulation  of 
rates.  A  value  predicated  on  a  breach  of  the  contract 
does  not  rest  on  a  very  sound  basis. 
Another  view  might  be  taken.     For  example,  an 


FRANCHISE      VALUES 


71 


enterprise  is  offered  involving  great  risks — such  as  New 
York's  first  subway.  No  one  wants  to  bid  for  it.  The 
franchise  is  worth  less  than  nothing.  The  city  offers 
special  inducements,  such  as  exemption  from  taxation 
and  the  use  of  its  credit  to  meet  the  cost  of  construc- 
tion. Then  a  bidder  appears  for  a  contract  to  build 
and  operate  the  road,  and  the  adventure  is  carried  out 
and  proves  to  be  a  great  success.  It  makes  a  great 
deal  of  money.  Of  course,  if  the  rate  cannot  be  re- 
duced for  the  term  of  the  grant,  and  the  public  cannot 
tax  the  enterprise,  the  contract,  after  it  is  shown  to  be 
a  success,  would  have  great  value.  But  this  is  not 
due  to  the  mere  permission  to  use  the  streets;  it  is  due 
to  the  immunity  from  taxation  and  the  unassailable 
rate  granted  at  the  beginning  as  compensation  for  the 
risk.  It  is  the  monopoly  feature,  not  subject  to  regula- 
tion, which  gives  the  value.  When  all  other  property 
can  be  destroyed  by  taxation  and  regulation,  it  is  worth 
something  to  be  free  from  such  burdens  for  a  while. 

But  such  a  franchise  is  most  unusual.  The  usual 
case  is  that  the  grantor  may  tax  the  enterprise,  and 
control  the  rates  charged  and  its  service.  Thus,  the 
earnings  may  be  so  reduced,  through  taxation  and  re- 
duction of  rates,  or  through  onerous  charges  in  the 
service,  that  an  enterprise  which  has  proved  to  be  more 
successful  than  was  anticipated  may  still  be  worth 
nothing  more  than  the  original  investment,  or  even 
less. 

On  the  other  hand,  if  the  power  to  regulate  be  used 
fairly,  consideration  would  be  given  to  the  risk  involved 
at  the  beginning,  and  the  fair  return  fixed  at  a  percent- 
age commensurate  with  such  risk.  The  risk  having 
become  a  thing  of  the  past,  and  the  rate  of  return 
permitted  being  commensurate  with  the  past  risk,  the 
stock  should  have  a  value  above  par.  The  investors 
are  to  enjoy  their  reward.  The  enterprise  can  be  sold 
at  a  profit  beyond  its  cost. 

Now,  it  is  not  exactly  the  permission  to  use  the  street 
which  is  worth  more;  it  is  the  permission  of  the  regulat- 
ing body  to  charge  enough  to  get  a  rate  of  return  larger 
than  the  normal  return  on  investments,  as  a  reward  for 
the  risk  assumed  in  the  past — a  risk  which  has  proved 
to  be  unfounded  by  the  happy  outcome.  It  is  the  good 
faith  of  the  community  which,  through  the  regulating 
body,  has  lived  up  to  the  true  intent  of  the  parties  to 
the  contract.  This  enhanced  value,  it  seems  to  me, 
should  be  attributed,  not  to  the  franchise,  but  to  other 
elements  in  the  enterprise.  If  we  include  in  going 
value  all  of  the  cost  of  establishing  the  business,  then 
it  should  be  treated  as  a  part  of  the  going  value. 


Among  the  costs  of  establishing  the  business  is  the 
price  paid  for  the  capital  of  the  original  investors,  for 
the  bright  idea  of  the  original  promoter  and  for  the 
skill  and  energy  put  into  the  adventure.  We  know 
what  usually  takes  place.  The  bonds  are  issued  with 
a  bonus  of  stock.  The  services  of  the  promoters  are 
paid  in  stock.  The  value  of  the  stock  depends  upon 
the  success  of  the  enterprise.  If  the  enterprise  fails,  it 
is  worthless.  If  it  succeeds,  those  who  take  the  risk 
are  entitled  to  a  reward  for  their  risk.  The  permission 
to  use  the  streets  is  not  the  basis  of  the  success,  although 
a  necessary  preliminary  to  the  experiment.  Success  is 
primarily  due  to  the  foresight  of  the  promoters  and  the 
courage  of  the  investors  and  the  skill  of  the  managers. 
The  managers  are  presumably  paid  by  the  investors  as 
they  go  along.  But  the  return  to  the  investors  should 
be  what  was  held  out  as  an  inducement  when  they 
embarked  on  the  adventure.  The  obligation  to  them 
was  incurred  at  the  time  the  risk  existed. 

A  frank  recognition  of  this  element  as  a  distinct  obli- 
gation of  the  enterprise — perhaps  as  something  to  be 
gradually  retired  after  a  reasonable  period — would  go 
a  long  way  toward  bringing  about  that  security  which 
Mr.  Wilcox  recognizes  as  so  desirable  and  making  an 
investment  in  a  regulated  public  service  enterprise  more 
attractive  to  capital.  This  does  not  at  all  imply  that 
the  liberality  of  the  original  promoters  in  distributing 
stock  should  be  binding  on  the  appraisers,  any  more 
than  it  is  with  respect  to  discounts  on  bonds. 

It  is  always  a  matter  for  inquiry  what  causes  the 
success  of  a  successful  enterprise.  No  one  ever  pre- 
tended that  the  success  of  a  trust  company  should  be 
attributed  to  its  permission  from  the  state  to  form  a 
corporation.  Why  should  we  attribute  to  the  privilege 
to  use  the  streets  the  success  of  a  telephone  company? 
The  permission  to  engage  in  the  enterprise  is  no  more 
the  sole  element  of  value  beyond  the  tangible  property 
actually  employed  in  the  operation  of  a  franchise  than 
is  the  lease  in  the  case  of  the  business  carried  on  upon 
the  leased  premises. 

We  need  a  more  correct  understanding  and  a  better 
analysis  of  the  elements  of  costs  and  values  in  all  kinds 
of  enterprises  if  we  are  to  reach  sound  conclusions  in 
valuing  franchises.  We  must  recognize  other  factors  in 
addition  to  tangible  property  and  franchises  when  they 
are  present.  Whether  these  factors  should  be  included 
in  going  value,  or  dealt  with  independently,  they  are 
surely  assets  which  enter  into  almost  every  established 
business,  and  to  omit  them  from  the  valuation  of  public 
service  corporations  must  lead  to  an  unfair  result. 


72 


THE      UTILITIES      MAGAZINE 


SOME  DISTINCTIONS   BETWEEN  THE  LEGAL  AND  ADMINISTRATIVE  PHASES   OF 

FRANCHISE  VALUATION 

By  Chester  A.  McLain 

Lecturer,  Harvard  University 


Much  of  the  confusion  in  the  discussion  of  franchise 
valuation  springs  from  a  failure  to  segregate  carefully  two 
distinct  aspects  of  the  problem,  the  legal  or  constitutional 
aspect  and  what  may  be  called  the  social-economic  or  ad- 
ministrative aspect. 

In  most  of  the  cases  which  come  before  our  appellate 
courts,  except  in  so  far  as  those  courts  have  by  statute  been 
given  a  general  power  to  renew  the  findings  of  an  adminis- 
trative tribunal,  the  sole  question  is  one  of  constitutional  law; 
whether  the  particular  action  of  the  legislature  or  adminis- 
trative authorities  constitutes  a  taking  of  property  without 
due  process  of  law  or  an  impairment  of  the  obligation  of 
contracts.  The  considerations  which  enter  into  the  solution 
of  this  narrow  legal  question  are  entirely  different  from  the 
considerations  which  confront  an  administrative  commission 
in  regulating  the  charges  of  a  public  utility.  Such  a  com- 
mission is  bound  to  consider,  not  alone  how  far  they  can 
legally  go  in  paring  down  the  rates  charged  by  the  public 
utility,  but  how  far  they  ought  to  go,  having  regard,  not 
only  to  the  securing  of  cheap  and  adequate  service  to  the 
public,  but  also  to  the  fair  treatment  of  those  who  have  in- 
vested their  capital  in  the  pubUc  service  and  to  the  possibility 
of  securing  future  advancements  of  capital  when  needed. 

Our  courts,  on  the  other  hand,  have  repeatedly,  and  with 
good  reason,  asserted,  that  the  wisdom  of  policy  of  particular 
legislative  or  administrative  action  is  not  open  to  question 
before  them  in  a  constitutional  case,  but  that  the  sole  point 
for  discussion  is  the  legaUty  of  such  action  under  a  reasonable 
interpretation  of  constitutional  powers  and  limitations.  It 
is  no  doubt  true  that  the  courts  have  not  always  drawn  this 
clean-cut  line  between  the  legal  and  economic  phases  of  the 
case  before  them,  and  that  the  judges  have  not  always  re- 
sisted the  temptation  to  impose  their  own  social  and  economic 
ideas  upon  legislatures  and  administrative  boards,  but  this 
is  all  the  more  reason  why  we  should  insist  on  a  clear  separa- 
tion of  these  two  distinct  phases  of  the  problems  in  the  future. 

A  franchise,  in  the  sense  in  which  we  use  it  here,  has  been 
universally  defined  as  a  special  privilege  conferred  by  the 
government  upon  individuals.  In  this  connection  two 
classes  of  privileges  are  to  be  distinguished.  The  first  in- 
cludes those  franchises  which  grant  to  private  individuals 
the  privilege  of  using  private  property  in  a  manner  not 
usually  enjoyed  by  people  in  general.  Such  would  be  the 
privilege  given  to  a  railroad  to  operate  on  private  right  of  way 
as  a  common  carrier  and  collect  tolls,  or  the  right  given  to 
private  individuals  to  organize  and  act  as  a  corporate  unit. 
The  other  class  includes  those  franchises  which  grant  to 
individuals  the  privilege  of  using  public  property  for  private 
gain.  Such  would  be  the  right  given  to  a  street  railway  to 
lay  its  rails  and  operate  its  cars  on  the  pubUc  highway. 

Both  of  these  classes  of  franchises  are  valuable  privileges 
of  which  the  holder  cannot  constitutionally  be  deprived 


without  due  process  of  law.  But  the  valuable  right  which 
the  Constitution  protects  is  necessarily  measured  by  the 
terms  of  the  privilege  itself.  The  constitutional  right  not  to 
be  deprived  of  property  without  due  process  of  law  does  not 
enlarge  the  property  right  so  protected,  but  merely  protects 
it  in  its  existing  extent  with  all  its  congenital  Hmitations. 

The  privilege  of  using  private  property  in  the  public  service 
is  necessarily  hmited  by  the  state's  power  to  regulate  the 
charges  for  such  service,  and  in  the  absence  of  express  words 
to  the  contrary  the  state  will  not  be  presumed  to  have  di- 
vested itseK  of  this  power  to  regulate  public  utilities.  This 
power  is  itself  circumscribed  by  the  constitutional  limitation 
that  the  state  cannot  reduce  the  charges  below  the  point  at 
which  the  public  utility  is  enabled  to  earn  a  reasonable  return 
on  the  fair  value  of  the  property  which  has  been  devoted  to 
the  public  service. 

The  resultant  of  these  two  limitations  is  a  privilege  to  use 
private  property  in  the  pubHc  service  subject  to  the  power  of 
the  state  to  reduce  the  charges  for  the  services  so  rendered 
to  a  point  at  which  they  yield  only  a  reasonable  return  on 
the  fair  value  of  that  property.  This  in  itself  is  a  valuable 
right  and  if  it  is  based  on  a  binding  contract  with  the  state 
(and  such  a  contract  will  not  be  lightly  presumed)  probably 
the  holder  cannot  be  deprived  of  it  without  fair  compensation, 
although  it  has  never  been  expressly  decided  that  compensa- 
tion is  necessary  to  due  process  of  law  in  eminent  domain 
proceedings.  If,  however,  it  is  not  based  on  a  binding  con- 
tract, although  it  may  still  be  valuable,  it  is  revocable,  and 
may  be  taken  away  at  any  time  without  compensation. 

Moreover,  although  it  is  a  valuable  privilege  and  as  such 
within  the  protection  of  the  Constitution,  it  does  not  follow 
that  the  holder  can  claim  the  right  to  earn  a  return  on  the 
value  of  the  privilege  as  such,  apart  from  the  value  of  the 
property  used  in  the  exercise  of  the  privilege.  For  upon  any 
reasonable  interpretation  of  the  franchise,  it  is  no  more  than 
a  privilege  to  earn  a  fair  return  on  the  property  devoted  to  the 
public  service  exclusive  of  the  privilege  itself.  This  is  so 
for  the  simple  reason  that  any  other  interpretation  leads 
inevitably  to  the  result  that  the  state  has  deprived  itself  of 
the  power  of  regulating  the  charges  of  this  pubhc  utihty,  a 
power  of  which  the  state  can  never  be  presumed  to  have 
divested  itself  without  express  words.  For  the  value  of  this 
privilege  is  determined  solely  by  its  earning  power,  which  in 
turn  depends  upon  the  rates  which  can  be  charged  under  it, 
and  if  the  public  utihty  can  lay  claim  to  be  protected  in  the 
right  to  earn  a  fair  return  on  such  a  valuation,  no  reduction 
of  rates  is  possible  without  invading  that  right.  In  this 
connection  too  much  emphasis  cannot  be  laid  upon  the  prin- 
ciple that  grants  by  the  state  shall  be  construed  strictly 
against  the  grantee,  and  that  the  state  can  never  be  presumed 
to  have  granted  away  its  power  to  regulate  the  charges  of 
public  utilities. 


FRANCHISE      VALUES 


73 


The  second  class  of  franchises  present  more  serious  diflS- 
culties,  because  they  may,  or  they  may  not,  confer  upon 
their  holders  property  rights,  in  the  strictest  legal  sense,  in 
the  public  highway.  Some  jurisdictions  seem  definitely  to 
have  committed  themselves  by  statute  or  judicial  decision 
to  the  proposition  that  a  franchise  to  use  the  public  streets 
confers  upon  the  grantee  a  property  interest  in  the  streets 
in  the  nature  of  an  easement.  In  those  jurisdictions  it  is 
difficult  to  escape  the  conclusion  that  the  holders  of  such 
rights  are  constitutionally  entitled  to  earn  a  reasonable  return 
on  the  fair  value  of  the  property  thus  devoted  to  the  public 
service.  But  such  property  can  have  no  appreciable  value 
apart  from  the  privilege  of  using  it  in  the  public  service,  and 
when  such  rights  are  valued  as  they  universally  are  valued, 
on  the  basis  of  their  earning  capacity,  it  is  submitted  that 
something  more  is  being  valued  than  the  mere  right  of  way 
in  the  public  street.  An  additional  element  of  value  is 
being  included  for  the  privilege  of  using  the  right  of  way  in 
the  public  service,  and  that  privilege,  as  has  been  seen, 
extends  no  farther  than  the  right  to  earn  a  reasonable  return 
on  the  fair  value  of  the  property  devoted  to  the  public  service 
exclusive  of  the  privilege  itself. 

The  conclusion  to  which  this  brings  me  is,  that,  so  far  as  the 
narrow  question  of  constitutional  limitations  is  concerned, 
a  franchise  as  such  can  never  be  considered  as  an  element  of 
value  for  rate  purposes,  and  that  unless  the  franchise  is  based 
upon  a  binding  contract  with  the  state,  it  can  be  taken  away 
by  the  state  at  any  time  without  compensation. 

The  fact  that  a  franchise  may  be  taxed  as  such  by  the 
state  is  not  in  the  least  inconsistent  with  this  conclusion,  for 
all  valuable  privileges  are  subject  to  taxation.  You  may 
be  taxed  on  the  privilege  of  buying,  selling,  borrowing,  eating, 
or  drinking,  and  they  are  all  valuable  privileges,  but  not 
that  such  privileges  are  property. 

The  social  economic  aspect  of  the  problem  calls  for  a 
broader  and  more  liberal  treatment,  and  while  we  may  well 
sympathize  with  those  who  are  inclined  to  view  all  claims 
advanced  by  public  utilities  through  the  glass  of  suspicion, 
we  should  not  let  our  wrath  at  the  tricks  which  have  been 
played  in  the  past  blind  us  to  the  real  problems  of  the  present. 
The  task  before  every  public  service  commission  today  is 
not  alone  to  use  all  its  powers  to  secure  adequate  service  for 
the  public  at  cheap  rates,  but  also  to  insure  the  continuance 
of  such  service  by  a  due  regard  to  the  fair  interest  of  those 
who  are  supplying  it  and  a  due  consideration  of  the  induce- 
ments necessary  to  attract  capital  to  such  interprises  in  the 
future.  To  this  end  it  seems  to  me  that  the  attempt  to 
apply  an  abstract  theory  of  justice  by  a  theoretical  valuation 
of  the  rights  and  interests  of  the  public  utility  is  entirely 
abortive.  Such  a  valuation  is  only  one  criterion  of  what  the 
utility  should  be  allowed  to  earn.  The  expression  "fair 
return"  properly  includes  more  than  the  simple  idea  of  the 
current  rate  of  interest  on  a  given  capital  sum. 

Had  I  time,  I  should  wish  to  enlarge  on  this  idea,  but  a 
single  example  must  suffice.  In  a  recent  investigation  it 
was  discovered  that  the  telephone  companies  in  New  York 
were  making  an  excessive  profit  and  a  reduction  of  rates  was 
recommended  to  the  extent  of  $3,000,000.     In  the  meantime 


it  developed  from  another  source  that  the  companies'  opera- 
tors were  not  receiving  a  living  wage,  and  it  was  strongly 
urged  that  a  part  of  this  $3,000,000  excess  be  distributed  in 
higher  wages  to  the  employees  rather  than  lower  rates  to  the 
public.  The  same  question  will  come  up  in  another  way  in 
the  Bay  State  Street  Railway's  petition  to  raise  its  fare  to 
six  cents,  now  being  heard  before  the  Massachusetts  Public 
Service  Commission.  One  of  the  reasons  urged  for  such  in- 
crease will  be  the  increased  expense  of  the  company  resulting 
from  a  recent  arbitration  award  in  favor  of  its  employees. 
Rate  regulating  authorities  can  scarcely  exclude  such  con- 
siderations from  the  problem  of  fair  return. 

But,  to  return  to  franchise  values,  if  those  who  have 
invested  in  a  pubHc  utility  have  done  so  in  reliance  on  a 
franchise  which  seems  to  promise  them  a  higher  and  more  cer- 
tain rate  of  return  than  they  would  receive  in  other  fields  of 
investment,  and  if  this  higher  and  more  certain  rate  was 
necessary  to  induce  such  investments,  a  public  service  com- 
mission in  facing  the  problem  of  regulating  the  charges  of 
that  utility  may  well  permit  it  to  earn  that  higher  rate  of 
return.  But  if  this  is  to  be  done,  it  should  be  done  openly  by 
increasing  the  rate  of  return  rather  than  padding  the  capital 
account  with  fictitious  values. 

Furthermore,  if  such  increased  rate  of  return  was  not 
necessary  to  induce  the  investment,  but  if,  on  the  other  hand, 
the  owners  of  the  utihty  entered  into  it  in  anticipation  of 
making  a  little  easy  money,  while  the  state  winked  at  the 
operation,  the  public  service  commission  is  certainly  not 
justified  in  permitting  the  public  utility  to  capitalize  that 
infarious  anticipation  and  demand  to  earn  dividends  upon  it. 
There  are  no  considerations  of  policy  which  demand  that  a 
public  utility  which  has  systematically  picked  the  pockets 
of  the  public  in  the  past  shall  be  confined  in  a  vested  right 
to  do  so  in  the  future. 

So,  also,  when  the  property  of  a  public  utility  operating 
under  a  revocable  franchise  is  being  taken  by  eminent  domain, 
the  assessing  authorities  may  well  consider  the  effect  on 
future  investments  in  public  utilities  of  the  taking  of  a  priv- 
ilege on  which  investors  have  been  led  to  rely  as  a  guarantee 
of  higher  and  more  certain  future  earnings  than  could  be 
received  in  other  enterprises,  and  they  may  well  think  it  wise 
to  pay  to  those  investors  a  bonus  by  way  of  consolation  for 
the  taking  of  this  privilege.  But  here  again  it  may  make  con- 
siderable difference  whether  this  anticipation  was  legitimate 
or  illegitimate.  For  certainly  the  state  is  under  no  obliga- 
tion, either  legal  or  moral,  to  compensate  a  private  individual 
for  depriving  him  of  the  expectation  of  illegitimate  profit 
from  mulcting  the  pubHc  with  exorbitant  rates. 

In  other  words,  the  circumstances  and  the  history  of  each 
particular  case  cannot  be  disregarded,  and  there  is  grave 
danger  of  making  the  problem  too  simple  in  the  attempt  to 
work  out  an  abstract  formula  to  settle  all  cases.  Experience 
has  shown  that  franchise  values  are  at  best  compromises, 
and  that  for  the  purposes  of  rate  regulation  any  real  attempt 
to  value  franchises  is  incompatible  with  any  regulation  of  the 
rates,  for  the  plain  reason  that  the  value  of  the  franchise 
depends  on  the  rate  which  it  is  proposed  to  regulate. 

These  are  problems  which  have  been  forced  upon  us  by 


74 


THE      UTILITIES      MAGAZINE 


the  inexperience  and  neglect  of  past  generations  in  failing 
to  safeguard  the  interests  of  the  state  in  the  conduct  of  public 
utilities.  For  the  future  it  should  be  looked  to  that  franchises 
shall  explicitly  exclude  any  possibility  of  founding  property 
rights  on  the  privileges  granted,  and  in  this  connection  the 


Wisconsin  undeterminate  permit  seems  a  worthy  model. 
But  we  should  also  guard  against  going  to  the  other  extreme 
so  far  as  to  discourage  the  investment  of  private  funds  in 
public  enterprise,  or  we  shall  force  the  future  generation  to 
meet  the  alternative  of  public  ownership  or  no  service. 


THEORY  OF  FRANCHISE  VALUES 

By  Alfred  Bettman 
Attorney  at  Law,  Cincinnati,  Ohio 


In  many  situations,  the  determination  of  the  amount  to 
be  allowed  for  franchise  value  is  a  matter  of  expediency  or 
poUcy  or  good  measure  or  compromise  or  the  price  of  peace. 
But  here  we  are  engaged  in  the  endeavor  to  ascertain  some 
general  principle  of  franchise  valuation  capable  of  general 
use  and  furnishing  at  least  a  starting  point  for  bargaining  in 
special  cases  and  for  clear  thinking  upon  disputed  points. 
In  such  an  endeavor  we  may  be  permitted  to  indulge  in  the 
deUghts  of  logic  and  consistency.  We  may  be  permitted  to 
go  behind  the  conventional  meanings  of  words,  such  as 
"condemnation,"  "value,"  etc.,  and  seek  for  the  essential 
characteristics.  The  capture  of  some  correct  and  consistent 
principle  of  franchise  valuation  can  be  best  accomplished  by 
examining  the  question  of  the  proper  measure  of  compensa- 
tion to  be  allowed  in  cases  of  condemnation  of  utilities  oper- 
ating under  term  or  perpetual  franchises.  We  are  here 
seeking  the  measure  of  value  of  a  franchise  treated  as  a 
separate  unit  or  subject  of  valuation. 

As  Dr.  Wilcox  has  pointed  out,  assessment  of  a  franchise 
for  taxation  is  of  so  special  a  character  that  the  methods 
involved  have  little  appHcation  outside  of  that  field.  In 
truth,  the  taxation  of  a  franchise  is  essentially  a  franchise 
fee  in  the  disguise  of  a  property  tax,  and  the  amount  of  it 
largely  a  matter  of  taxation  poUcy.  Except  possibly  in  an 
exceptional  situation,  such  as  that  of  the  New  York  Consoli- 
dated Gas  case,  the  absurdity  of  allowing  separate  franchise 
value  in  the  process  of  rate  regulation  is  obvious.  It  is  al- 
most equally  as  obvious  that  no  franchise  value  ought  to  be 
allowed  where  the  municipaUty  is  exercising  a  privilege  of 
purchase  contained  in  the  franchise  itself.  The  privilege 
of  purchase  is  a  privilege  to  terminate  the  franchise,  and  a 
terminated  franchise  cannot  justly  be  said  to  have  value. 
For  the  same  reason  an  indeterminate  franchise  or  permit 
has  no  separate  value,  and,  in  such  cases,  there  is  the  addi- 
tional reason  that  the  community,  by  means  of  its  power  of 
continuous  rate  and  other  regulation,  has  the  continuous 
power  of  reducing  franchise  value  to  the  vanishing  point. 
For  this  latter  reason  also,  any  franchise  which,  according  to 
the  laws  of  the  state  in  which  it  is  granted,  places  no  limita- 
tion upon  the  power  of  the  public  to  regulate  rates  and  other 
matters,  except  the  constitutional  limitation  of  a  fair  return 
uj)on  a  fair  value,  is  not  a  subject  of  separate  valuation  as  a 
separate  unit;  for  it  is  difficult  to  see  any  justification,  moral 
or  otherwise,  for  requiring  the  public  to  pay  extra  because 


the  public  has  seen  fit  to  be  indulgent  in  the  exercise  of  its  full 
regulatory  powers. 

The  search  for  a  general  principle  of  franchise  valuation 
would  seem,  therefore,  to  narrow  itself  to  the  question  of 
the  proper  basis  of  compensation  to  be  paid  in  cases  where 
the  public  by  involuntary  proceedings,  such  as  condemna- 
tion proceedings,  acquires  a  public  utility  plant  to  which  is 
attached  a  franchise  in  which  for  a  specified  term  of  years  or 
perpetually  the  public  has  surrendered  some  of  its  regulatory 
powers.  The  special  case  where  the  utility  has  actually  paid 
for  a  franchise  may  be  excluded  from  further  consideration 
for,  obviously,  except  to  the  extent  of  the  amount  paid,  such 
a  franchise  does  not  differ  in  value  from  a  franchise  given 
without  payment. 

ESSENTIAL  NATURE  OF  CONDEMNATION  OF 
UTILITY  FRANCHISE 

Applying  ourselves,  therefore,  to  this  subject  of  compensa- 
tion in  condemnation  proceedings,  we  will  find  that  the  more 
we  analyze  and  reason,  the  more  we  become  convinced  that 
the  man  who  first  spoke  of  franchise  value  as  an  intangible 
value  was  not  guilty  of  gross  exaggeration.  Analysis  and 
logic  land  us  at  the  conclusion  that  the  only  principle  which 
can  be  consistently  applied  is  that  the  franchise  be  recognized 
as  performing  the  function  of  giving  full  protection  to  the 
investment  and  a  fair  return  thereon,  and  that  in  the  per- 
formance of  this  function  it  exhausts  itself,  leaving  nothing 
further  to  be  valued. 

For  instance,  let  us  examine  the  essential  nature  of  a  pro- 
ceeding by  a  mimicipality  to  acquire  a  pubhc  utility.  When  a 
city  is  authorized  by  constitution,  charter,  or  statute  to 
acquire  and  operate  a  pubhc  utility,  the  operation  of  the 
utility  by  the  municipahty  will  not  be  by  virtue  of  the 
franchise  of  the  utility  company,  but  by  virtue  of  the  city's 
powers  as  granted  in  the  constitution,  charter  or  statute. 
The  municipaUty  does  not  need  the  company's  franchise  at 
all.  A  term  or  perpetual  franchise  so  exclusive  that  the 
city  could  not  constitutionally  be  authorized  to  operate  on 
its  own  streets,  is  almost  unthinkable  and  certainly  very 
rare.  In  every  case  other  than  such  an  exclusive  franchise, 
there  can  be  no  doubt  that  the  public  does  not  need  the  com- 
pany's franchise.  The  power  given  to  the  city  to  take  by  con- 
demnation proceedings  would  seem  on  analysis,  therefore, 
to  be  a  power  to  destroy  the  franchise  rather  than  the  power 


FRANCHISE      VALUES 


75 


to  take  it  for  public  use.  It  is  doubtful,  however,  whether 
the  constitutions  of  the  various  states  permit  the  taking  of 
private  property  for  the  purpose  of  destruction  as  dis- 
tinguished from  the  purpose  of  use.  Where  a  city  takes  an 
improved  piece  of  real  estate  for  the  purpose  of  con- 
structing a  police  station,  the  intention,  of  course,  is  to 
destroy  the  building  existing  upon  the  property.  But  this 
destruction  is  simply  a  necessary  incident  in  the  use  of  the 
property  for  a  pohce  station;  whereas,  to  operate  a  utility, 
the  community  does  not  need  the  company's  franchise  at 
all  and  can  leave  it  in  ownership  of  the  company.  If  it  be 
argued  that  the  taking  of  the  plant  destroys  the  value  of  the 
franchise  and  therefore  the  full  value  of  the  franchise  should 
be  paid,  such  argument  implies  a  confession  that  the  fran- 
chise without  the  plant,  that  is  the  franchise  considered  as  a 
separate  unit,  really  has  no  value.  In  the  final  analysis, 
therefore,  there  would  seem  to  be  justification  for  the  conclu- 
sion that  a  statute  granting  to  the  community  the  power  of 
acquiring  a  public  utility  by  involuntary  proceedings  is 
essentially  a  statute  providing  for  revocation  of  the  fran- 
chise, contingent  upon  the  community's  taking  and  paying  a 
price  for  the  plant  which  will  protect  the  investment  made  in 
reliance  on  the  franchise;  or,  more  accurately,  such  a  statute 
may  be  interpreted  as  inserting  a  privilege  of  purchase  into 
the  franchise  itself,  and  the  question  of  franchise  valuation 
becomes  the  same  as  though  there  had  originally  been  such 
a  privilege  of  purchase  in  the  franchise.  A  case  such  as  the 
Monongahela  Navigation  Company  case  in  148  U.  S.,  in 
which  one  sovereign  political  community,  the  United  States, 
was  seeking  to  take  or  destroy  a  franchise  granted  by  an- 
other sovereign  political  community,  the  State  of  Pennsyl- 
vania, is  very  special  in  its  nature  and  the  above  analysis 
may  not  fit  such  a  case. 

Other  lines  of  reasoning,  into  which  time  does  not  permit 
me  to  go,  will  be  found  to  land  us  at  the  same  destination. 
We  all  know,  of  course,  that  this  conception  of  the  nature  of 
proceedings  to  acquire  a  utility  is  not  the  prevailing  concep- 
tion as  embodied  in  judicial  decisions,  valuation  practice 
and  expert  opinions,  although  many  cases  do  contain  hints 
in  support  thereof,  and  a  few  cases  more  or  less  avowedly 
adopt  this  conception.  Often  the  language  of  the  statute 
under  consideration  will  preclude  any  such  interpretation. 
We  must  all  confess,  however,  that  the  prevaiUng  methods 
used,  in  and  out  of  courts,  for  determining  franchise  values 
contain  much  confusion  and  inconsistency,  or  at  least  much 
vagueness.  An  example  is  the  one  so  clearly  pointed  out  by 
Dr.  Wilcox,  where  the  utiUty  is  taken  during  the  existence 
of  a  term  franchise,  yet  the  physical  property  is  valued  on 
the  basis  of  an  indeterminate  permit  to  which  is  added  a 
franchise  value  on  the  basis  of  a  term  franchise.  Dr.  Wilcox 
recognizes  that  there  is  no  chance  for  obtaining  an  inexorably 
logical  treatment  of  term  franchises,  that  is  for  physical  val- 
uations based  on  the  assumption  that  during  each  year  of  a 
term  franchise  the  plant  is  continuously  proceeding  toward 
a  mere  scrap  value  and  the  plant  valuation  must  therefore 
be  reduced  in  proportion  to  the  number  of  years  of  the  fran- 
chise which  have  expired  at  the  time  of  the  public's  acqui- 
sition.    Dr.    Wilcox    suggests    some    halfway    compromise 


between  the  logic  of  full  recognition  of  the  nature  of  a  term 
franchise  and  the  logic  of  the  prevailing  practice;  but  he  is 
naturally  unable  to  give  any  formula  for  this  compromise. 

The  confusion  and  inconsistencies  which  permeate  dis- 
cussions of  the  subject,  both  in  judicial  opinions  and  the  lit- 
erature of  the  subject,  arise  from  several  fallacies.  Firstly, 
the  analogies  of  public  service  property  to  private  property 
are  overstated.  Secondly,  there  is  the  fallacy  of  assimiing 
that  the  Constitution  prescribes  value  as  the  test  of  com- 
pensation to  be  paid  when  property  is  taken  for  a  pubHc  use, 
whereas,  constitutions  almost  universally  prescribe  just  com- 
pensation, which  may  or  may  not  be  the  same  as  value  in 
the  usual  sense  of  that  word.-  And  then  there  is  misappre- 
hension and  ambiguity  regarding  the  meaning  of  value. 
Value  ordinarily  means  market  value,  and  this  is  the  mean- 
ing given  to  it  in  appropriations  of  purely  private  property; 
but  for  many  reasons  this  is  not  the  meaning  which  can  be 
given  where  the  discussion  relates  to  the  amount  to  be  paid 
for  public  service  property,  and  the  courts  have  not  attempted 
to  adhere  to  market  value  as  the  basis  of  compensation  to  be 
paid  for  such  property.  We  find  courts  constantly  admit- 
ting evidence  appropriate  to  valuation  upon  historical  cost 
basis  or  actual  cost  basis  or  reproductive  cost  basis.  All 
such  evidence  relates  to  cost  and  not  to  value,  and  such 
evidence  is  generally  and  rightly  excluded  from  cases  upon  the 
value  of  purely  private  property.  Cases  of  condemnation 
of  utility  property  have  been  exceedingly  few,  dealing  mostly 
with  toll  bridges,  toll  roads,  and  a  few  water  plants.  There 
has  been  so  much  study  and  discussion  of  utility  valuation 
since  the  decisions  which  have  set  the  precedents,  that  the 
questions  involved  cannot  be  considered  as  closed  questions, 
and  this  new  learning  will  inevitably,  as  it  should,  affect  the 
attitude  of  courts.  Principles  and  theories  which  hang 
together,  which  can  stand  analysis  and  which  recognize  the 
peculiar  nature  of  public  utility  property  will  eventually  win 
the  approval  of  the  courts. 

The  question  immediately  arises  as  to  whether  a  statute, 
which,  by  express  provision  or  interpretation,  provides  for 
the  pubhc  acquisition  of  privately  owned  utilities  and  ter- 
mination of  their  franchises  upon  payment  of  compensation 
which  will  fully  protect  the  investment,  is  constitutional. 
Time  does  not  permit  a  full  discussion  of  this  question.  The 
implications  of  the  Milwaukee  street  railroad  fare  case  sup- 
port the  constitutionality  of  such  provisions.  The  Wisconsin 
statute  converting  all  existing  term  franchises  into  indeter- 
minate permits,  together  with  the  view  of  the  Wisconsin 
Railroad  Commission  that  this  conversion  does  not  entail 
an  allowance  for  franchise  value  in  the  fixing  of  the  price 
to  be  paid  for  the  utility,  constitutes  a  legislative  recognition 
of  the  principle  that  the  proper  function  of  a  franchise  is  to 
give  security  to  the  investment  and  it  should  be  valued  ac- 
cordingly. Most  state  constitutions  contain  a  reserve  power 
in  the  legislature  to  repeal  or  amend  special  privileges  or 
corporate  charters;  and  this  reserve  power,  together  with  the 
tendency  of  the  courts  to  interpret  franchises  as  not  consti- 
tuting a  surrender  of  the  state's  general  power  to  regulate 
rates,  service,  etc.,  may  be  found  sufficient  to  support  gen- 
erally the  principle  upon  which  the  Wisconsin  legislature  and 
commission  have  proceeded. 


76 


THE      UTILITIES      MAGAZINE 


ACTUAL  COURT  PRACTICE  IN  VALUING 
FRANCHISES 

Turning  for  a  moment  from  the  consideration  of  theoret- 
ical analysis  to  the  actual  practice  of  courts,  we  find,  as  is 
well  known,  that  courts  generally  require  the  franchise  to  be 
considered  as  a  subject  of  valuation.  Some  courts  decree 
earning  capacity  as  the  basis  of  compensation,  not  for  the 
franchise  as  a  separate  unit,  but  for  the  franchise  and  plant 
combined,  on  the  theory  that  the  proceedings  consist  of  the 
deprivation  of  an  earning  capacity  and  it  is  the  value  of 
this  earning  capacity  which  must  be  paid.  This  theory  and 
method  has  much  logic  in  its  favor  and  can  be  consistently 
applied;  but,  if  consistently  applied,  it  would  fail  to  satisfy 
many  utilities,  particularly  those  which  have  a  low  percentage 
of  earning  capacity  and  it  would  often  result  in  injustice  to 
such  utilities.  Strictly  this  method  makes  irrelevant  all 
evidence  of  plant  value,  such  as  evidence  bearing  on  actual 
or  reproductive  cost.  But  most  courts  admit  such  evidence. 
None  of  the  decisions,  however,  treats  the  franchise  as  a 
subject  of  valuation  separate  from  and  in  addition  to  the 
plant  valuation.  Generally  the  jury  or  commissioners  are 
permitted  to  receive  and  consider  figures  relating  to  both 
value  of  the  plant  as  a  physical  entity  and  values  of  the  plant 
and  franchise  based  on  earning  capacity,  without  receiving 
any  very  definite  assistance  as  to  how  to  co-ordinate  these 
figures  or  make  them  subserve  some  definite  and  consistent 
principle. 

FRANCHISE  VALUE  WHERE  PHYSICAL  VALUA- 
TION OF  PLANT  IS  USED 

Valuation  on  the  principle  that  the  function  of  the  fran- 
chise is  to  assure  private  operation  until  the  public  is  ready 
and  willing  to  pay  a  price  that  wiU  protect  the  actual  invest- 
ment of  the  utility  company,  will  almost  universally  do  full 
justice  to  all  parties  concerned.  Sometimes  it  will  give  the 
company  more  than  strict  justice — as  for  instance,  in  the 
case  of  a  utility  operating  under  a  term  franchise  whose 
earnings  are  insufiicient  to  amortize  the  investment  during 
the  term  of  the  franchise.  In  the  comparatively  rare  case 
of  a  utility  whose  earning  capacity  is  in  excess  of  the  amount 
necessary  to  earn  a  fair  return  on  and  also  amortize  the 
investment,  there  is  some  equity  in  requiring  an  extra  allow- 
ance for  franchise  value  representing  the  present  value  of 
this  excess  earning  capacity.  Where  the  plant  valuation  is 
not  based  on  investment  protection  but  upon  some  other 


method  or  principle  of  strictly  physical  valuation,  such  as 
actual  cost  of  existing  plant  or  reproductive  cost,  then  it  is 
obviously  just  that  payment  be  made  for  any  earning  capac- 
ity which  is  in  excess  of  a  fair  return  upon  the  plant  valua- 
tion; for  in  granting  the  term  or  perpetual  franchise,  the  pub- 
lic has  induced  investment  upon  not  merely  the  privilege  of 
building  and  operating  a  utihty  plant,  but  also  the  privi- 
lege of  operating  the  plant  free  to  some  extent  from  public 
regulation,  and  it  is  this  freedom  which  creates  the  excess 
earning  capacity. 

Earning  capacity  and  not  the  actual  earnings,  however, 
should  be  used  as  the  measure  of  compensation.  The  earn- 
ing capacity  should  be  measured  upon  the  assumption  that 
the  public  will  exercise  all  the  regulatory  powers  which  the 
public  has  not  expressly  agreed  to  surrender.  The  public 
ought  not  be  required  to  pay  for  its  own  indulgence  or  to 
pay  a  gambling  value  placed  by  the  market  upon  the  prob- 
ability that  this  indulgence  will  continue.  A  perpetual 
franchise  ought  to  be  even  less  generously  dealt  with,  and 
earning  capacity  measured  upon  the  assumption  that  the 
public  will  fully  exercise  all  regulatory  powers  which  the 
Constitution  will  permit. 

There  are  great  practical  difiiculties  in  calculating  earning 
capacity,  and  some  guesswork  may  often  have  to  be  used 
and  an  approximate  justice  arrived  at.  There  is  always 
the  danger  that  the  future  growth  of  earnings  will  be  exag- 
gerated. As  Dr.  Wilcox  has  so  well  demonstrated,  there  is 
also  the  danger  that,  under  different  guises,  the  same  fran- 
chise value  may  be  counted  twice  or  more.  For  instance, 
if  going  value  to  cover  early  losses  or  other  development 
expense  be  allowed  in  the  valuation,  such  allowance  can 
only  be  attributed  to  the  principle  of  investment  protection. 
Such  an  allowance  really  amounts  to  a  requirement  that  the 
pubUc  pay  for  a  non-existent  or  minus  earning  capacity,  so 
to  speak,  and  this  allowance  ought,  in  some  way,  to  be  taken 
into  account  in  calculating  a  franchise  value  based  on  earning 
capacity. 

If  compensation  be  carefully  calculated  according  to  earn- 
ing capacity  as  distinguished  from  actual  earnings,  probably 
very  few  utilities  will  be  found  to  have  any  considerable  value 
in  excess  of  the  amount  necessary  to  justly  protect  the  actual 
investment.  But  when  a  franchise  is  given  its  full  force  and 
vigor  as  the  protector  of  the  investment  and  a  fair  return 
thereon,  the  utility  company  will  seldom  have  any  just  cause 
for  complaint. 


OPEN  DISCUSSION 


Mk.  Harry  Barker,  Editor  of  Engineering  News: 
Mr.  McLain  has  given  a  very  careful  exposition  of  the 
legal  principles  back  of  the  idea  that  franchise  values  should 
not  enter  the  rate  basis  at  all.  Now,  such  law  doesn't  exist 
just  because  it  is  law,  but  because  it  is  crystallized  justice,  or 
crystallized  equity;  therefore,  there  is  a  parallel  statement 
to  what  Mr.  McLain  has  made,  but  in  more  popular  terms, 
which  I  think  ought  to  be  injected  into  the  proceedings.     I 


thought  that  Dr.  Wilcox  was  going  to  quote  this;  but  he 
stopped  just  short  of  it.  It  was  in  the  final  decision  of  the 
New  Jersey  Court  of  Errors  and  Appeals  in  the  Passaic  90 
cent  gas  case  in  the  concurring  opinion  of  Justice  White. 
He  states  that  the  francise  value  is  property  and  subject  to 
the  protection  of  the  state;  but  it  is  not  property  used  and 
useful  in  the  service  of  the  public,  and  therefore  does  not 
enter  rate-basis  value.     That  is  a  simple  economic  concept, 


LAND      VALUES 


77 


which  Mr.  McLain  has  explained  very  carefully  in  legal 
phraseology. 

Justice  White  goes  to  another  simile  which  amplifies  the 
idea.  He  says  that  franchise  value,  that  is  in  general  and 
not  in  exceptional  cases,  is  a  stream  which  springs  out  of  the 
right  of  the  contract  of  the  company  to  earn  a  reasonable  rate 
on  a  reasonable  value.  That  stream  cannot  rise  higher  than 
its  source;  and,  therefore,  cannot  enter  into  the  basis  of  that 
reasonable  value.    The  major  part  of  the  opinion  reads  thus: 

"I  suppose  it  must  be  conceded  that  the  franchise  to  charge 
as  a  'reasonable  rate,'  sufficient  to  yield  a  net  profit  of  8  per 
cent  on  the  value  of  the  company's  property  as  allowed  and 
established  respectively  by  the  findings  of  the  UtiUties  Com- 
mission in  this  case,  is  a  very  valuable  property  right.  Cer- 
tainly I  think  it  is.  That  this  valuable  privilege  is  the  com- 
pany's is  beyond  question.  That  it  is  property  is  undoubted. 
That  the  law  protects  it  against  confiscation  and  subjects  it 
to  taxation  follows  as  a  matter  of  course.     But  that  this  valu- 


able property  right  to  charge  'reasonable  rates'  should  by 
virtue  of  its  own  existence  have  the  effect  of  converting 
itself  into  a  still  more  valuable  property  right  to  charge  '  un- 
reasonable rates'  is,  of  course,  preposterous.  Presumably 
the  incorporators  went  into  this  public-utility  business 
because  they  expected  that  their  charter  privilege  to  charge 
'reasonable  rates'  for  the  gas  they  were  to  manufacture,  dis- 
tribute and  sell  would  be  a  valuable  one,  but  that  fact  and 
the  fact  that  it  has  become  so  cannot  have  the  effect  of  alter- 
ing the  terms  of  the  contract  made  with  the  state.  .  .  .  . 
"That  the  company's  contract  with  the  state  to  charge 
'reasonable  rates'  cannot  be  thus  evaded  is,  of  course,  quite 
obvious.  The  plain  fact  is  that  the  commercial  value  of  the 
company's  property  right  in  its  franchise  can  have  no  effect 
in  fixing  the  rate  it  can  charge,  because  by  the  terms  of  its 
contract  with  the  state  the  stream  of  its  franchise  value 
arises  from  the  spring  of  its  right  to  charge  'reasonable 
rates,'  and  in  the  very  nature  of  things  no  stream  can  rise 
higher  than  its  source." 


PRINCIPLES  TO  BE  APPLIED  IN  VALUING  LAND 


FUNDAMENTAL  PRINCIPLES  OF  VALUATION 

A  DESCRIPTION  of  the  method  to  be  pursued 
in  ascertaining  the  present  value  of  the  land 
of  a  public  utility  company  cannot  be  begun 
without  eliminating  the   many   irrelevant   arguments 
and  theories  which  have  been 
introduced  in  practically  all  dis- 
cussions of  methods  of  valua- 
tion.   This  can  best  be  done  by 
accepting  as  fundamental   the 
principles   of    valuation   which 
were  laid  down  by  the  court  in 
the  decision  of  Smythe  vs.  Ames 
(169 U.S. pages 546-547).    The 
court  therein  said: 


By  Hammond  V.  Hayes 

Consulting  Engineer,  Boston,  Mass. 

for  consideration,  and  are  to  be  given  such  weight  as  may  be 
just  and  right  in  each  case.  We  do  not  say  that  there  may 
not  be  other  matters  to  be  regarded  in  estimating  the  value 
of  the  property.  What  the  company  is  entitled  to  ask  is  a 
fair  return  upon  the  value  of  that  which  it  employs  for  the 
pubUc  convenience.  On  the  other  hand,  what  the  pubhc  is 
entitled  to  demand  is  that  no  more  be  exacted  from  it  for 

the  use  of  a  public  highway  than 
the  services  rendered  by  it  are 
reasonably  worth." 


PART  IV 
LAND   VALUES 


"We  hold,  however,  that  the 
basis  of  all  calculations  as  to  the 
reasonableness  of  rates  to  be 
charged  by  a  corporation  main- 
taining a  highway  under  legisla- 
tive sanction  must  be  the  fair 
value  of  the  property  being  used 
by  it  for  the  convenience  of  the 

pubhc.  And  in  order  to  ascertain  that  value,  the  original 
cost  of  construction,  the  amount  expended  in  permanent 
improvements,  the  amount  and  market  value  of  its  bonds 
and  stock,  the  present  as  compared  with  the  original  cost 
of  construction,  the  probable  earning  capacity  of  the  prop- 
erty under  particular  rates  prescribed  by  statute,  and  the 
sum  required  to  meet  operating  expenses,  are  all  matters 


METHODS  USED  IN  VALUING  LAND 

LAND    VALUES    UNDER    THE    MINNESOTA 
RATE  CASE 

THE  MEASUREMENT  OF  LAND  VALUES 

WHAT  SHALL  BE  DONE  WITH  APPRECIATION 

ACTUAL  COST  AS  A  BASIS  FOR  LAND  VALUES 

VALUING    LAND    USED   BY   COMMON   CAR- 
RIERS 

THE  AGENCY  THEORY 

THE  SERVITUDE  OF  RAILWAYS 


If  this  decision  is  followed, 
the  subject  of  valuation  be- 
comes simple.  If  it  is  not  fol- 
lowed, literally  and  absolutely, 
the  complications  and  theories 
which  today  are  so  prevalent 
inevitably  follow.  In  the  above 
quoted  decision,  the  court  de- 
manded, among  other  things, 
figures  showing  the  original  cost 
of  the  property,  the  amount  and 
market  value  of  the  bonds  and 
stock,  and  the  present  cost  of 
construction. 
In  an  appraisal  the  original  cost  of  the  entire  property 
and  the  present  cost  of  the  entire  property  must  be 
found.  From  these  two  figures,  supplemented  by  the 
other  information  demanded  by  the  court,  the  fair 
"rate  base,"  the  "fair  capital  value,"  called  by  the 
court  the  "fair  present  value,"  is  to  be  obtained  not 


78 


THE      UTILITIES      MAGAZINE 


arbitrarily  nor  by  formula,  but  by  well  informed  judg- 
ment for  each  particular  case. 

For  the  valuation  of  land,  therefore,  two  figures 
must  be  obtained  by  appraisers;  (1)  the  original  cost 
of  the  land;  and  (2)  what  it  would  cost  a  public  utility 
company  to  acquire  that  land  at  the  time  of  an  appraisal. 

II 
METHOD  TO  BE  USED  IN  VALUING  LAND 

The  valuation  of  the  property  of  railroad  companies, 
now  being  carried  out  by  the  Interstate  Commerce 
Commission,  centers  interest  in  the  valuation  of  rail- 
way lands.  Moreover,  the  most  important  decisions 
bearing  upon  this^subject  have  been  in  cases  relating 
to  railroads.  For  these  reasons  the  following  discus- 
sion of  the  method  to  be  adopted  in  valuing  land  will 
be  confined  to  cases  of  railroad  companies. 

Before  any  question  of  the  value  of  land  can  be  con- 
sidered, two  figures  must  be  found,  one  representing 
the  original  cost  of  the  land  and  the  other  what  it 
would  cost  to  obtain  the  land  now  in  use  and  useful, 
if  held  in  private  ownership  and  acquired  by  the  rail- 
road company  at  the  time  of  the  appraisal.  This  last 
figure  is  the  cost  of  reproduction. 

An  analysis  of  both  the  original  cost  and  the  cost  of 
reproduction  shows  that  each  may  be  divided  into 
two  parts:  (1)  the  figure  which  would  be  assigned  in 
condemnation  proceedings  as  the  price  which  a  company 
should  pay  for  the  land  acquired  by  it,  and  (2)  the 
costs  of  condemnation,  of  damages,  and  of  purchase — 
including  costs  of  plats,  abstracts,  notarial  fees,  record- 
ing deeds,  and  similar  expenses. 

The  method  which  should  be  employed  in  ascertain- 
ing the  first  portion  of  both  the  original  and  the  repro- 
duction cost  is  that  in  which  the  normal  market  value 
is  ascertained  of  adjacent  similar  lands  as  revealed  by 
the  prices  paid  in  voluntary  private  sales,  both  at  the 
time  of  the  original  acquisition  of  the  lands  by  the  com- 
pany and  at  the  time  of  the  appraisal.  This  method  is 
familiar  to  all  who  have  had  experience  in  the  valuation 
of  lands  and  has  been  extensively  used  as  a  normal 
basis  for  the  ascertainment  of  the  reproduction  cost. 
There  are  two  features  of  the  recommended  method, 
however,  which  need  particular  emphasis:  one,  that 
the  normal  sales  value  of  adjacent,  similar  property 
should  be  found  not  for  the  time  of  the  appraisal  alone, 
but  as  of  the  date  of  the  original  acquisition  of  the 
land  under  valuation;  the  other,  that  each  parcel  of 
land — a  parcel  being  defined  as  a  separate  and  distinct 
purchase— be  associated  with  similar  adjacent  lands  of 
which  the  past  and  present  market  value  can  be  ascer- 
tained. In  addition  to  the  two  normal  basic  figures 
thus  found,  the  amount  paid  to  the  original  owner  of 


each  particular  parcel  should  be  found  and  entered 
against  that  parcel. 

By  this  method  the  price  paid  by  the  company  and 
the  normal  market  value  at  the  time  of  purchase  are 
shown  for  each  particular  parcel  and  there  is  revealed, 
by  the  ratio  between  these  two  figures,  the  difference 
between  the  cost  to  a  company  of  its  land  and  the 
amount  which  was  paid  at  that  time  in  voluntary  nor- 
mal sales  of  similar  land.  Moreover,  as  the  date  of 
acquisition  is  given,  it  will  be  possible,  in  many  in- 
stances, to  determine,  for  land  similar  in  character,  the 
trend  of  this  ratio  from  early  days  to  the  date  of  the 
appraisal.  The  ratio  of  the  price  the  company  has 
actually  paid  for  its  land  to  the  normal  market  value 
of  adjoining  similar  lands  is  thus  established  in  a  dis- 
tinct and  convincing  manner,  and  a  ratio  is  established 
by  the  use  of  which  the  reproduction  cost  may  be 
found  from  the  normal  market  value  of  similar  and 
adjacent  land  at  the  time  of  the  appraisal. 

It  will  be  contended  unquestionably  that  the  prac- 
tical difficulties  involved  in  carrying  out  this  method 
are  insuperable;  that  in  the  case  of  the  older  roads  the 
actual  cost  of  the  land  cannot  be  found,  and  that  there 
is  no  possibility  of  finding  at  the  present  time  what  the 
market  value  of  similar  adjacent  land  had  been  many 
years  ago.  Again,  it  will  be  argued  that  the  subdivi- 
sion of  the  railway  lands  into  parcels  is  an  academic 
refinement  and  that  equally  satisfactory  results  can 
be  obtained  by  their  division  into  groups  such  as  wild 
lands,  farming  lands,  or  town  land. 

It  must  be  admitted  that  difiiculties  will  be  found 
and  that  the  research  will  be  laborious  and  expensive 
in  many  cases.  On  the  other  hand,  the  court  and  the 
rate  making  tribunals  must  have  facts,  represented  by 
figures  which  can  be  supported,  to  show  that  a  public 
utility  company  did  not  and  does  not  pay  the  normal 
market  price  when  it  acquires  land  and  that,  for  the 
parcels  of  the  particular  character  under  valuation,  it 
has  always  paid,  and  would  be  liable  to  have  to  pay  at 
the  time  of  valuation,  the  normal  price  increased  by  a 
definitely  established  multiplier. 

Nor  can  the  difiiculties  incident  to  the  ascertainment 
of  the  original  cost  be  offered  as  an  excuse  for  a  neglect 
of  such  figures  in  a  valuation.  Congress  in  its  order  to 
the  Interstate  Commerce  Commission  to  value  the 
property  of  all  common  carriers  requires  that  the  Com- 
mission shall  investigate,  ascertain  and  report  "sepa- 
rately from  improvements  the  original  cost  of  all  lands, 
rights  of  way,  and  terminals  ....  and  separ- 
ately the  original  and  present  cost  of  condemnation 
and  damages  or  of  purchase  in  excess  of  such  original 
cost."  This  requirement  is  logical,  sound,  and  is  one 
that  should  be  made  for  all  investigations  relative  to 
the  cost  of  property  of  this  character. 


LAND      VALUES 


79 


The  figures  obtained  through  the  use  of  the  method 
above  advocated  give  the  original  cost  and,  for  the 
reproduction  cost,  the  price  which  a  company  has  paid 
and  in  all  reasonable  probability  would  have  to  pay  at 
the  present  time  for  the  land  now  used  for  the  benefit 
of  the  public.  It  eliminates  the  necessity  of  any  assump- 
tions as  to  what  a  company  has  paid  or  would  have  to 
pay  for  encumbrances  upon  the  property,  or  for  sever- 
ance, for  damages,  for  suitability  or  similar  claims 
which  in  the  past  have  been  made  in  many  claims  for 
land  values.  The  actual  cost  to  the  company  of  the 
land  which  it  owns  includes  all  such  elements  of  value. 
They  are  shown  as  far  as  they  need  be  by  the  difference 
between  the  market  value  of  adjacent  similar  lands  and 
the  prices  actually  paid.  There  is  introduced  no 
element  of  personal  opinion  or  judgment,  however 
honest  and  wise.  The  figures  represent  facts  as  nearly 
as  facts  can  be  ascertained  under  existing  conditions. 

An  objection  may  be  raised  to  these  groups  of  figures 
on  the  ground  that  the  company  may  have  paid  ori- 
ginally more  than  it  should.  This  objection  cannot 
be  well  taken  in  such  cases  as  the  land  had  been  ac- 
quired through  condemnation  proceedings.  Such  evi- 
dence is  definite  and  convincing.  On  the  other  hand, 
where  land  has  been  acquired  by  private  purchase,  the 
company  should  be  given  the  benefit  of  the  doubt.  It 
is  a  reasonable  and  fair  presumption  that  each  com- 
pany has  exercised  its  best  judgment  in  purchasing 
land  by  private  sale  rather  than  through  condemna- 
tion proceedings  and  in  thus  acquiring  its  land  as 
cheaply  as  possible. 

Again,  objection  may  be  raised  to  the  plan  here 
advocated  on  the  ground  that  the  ratio  of  original  cost 
to  normal  value  would  be  distorted  in  cases  where  the 
land  had  been  donated.  This  objection  is  not  well 
taken  if  the  ratio  assigned  to  find  the  reproduction 
cost  is  derived  by  the  means  of  curves  here  advocated. 
It  is  true  that  if  the  ratio  of  the  cost  of  donated  land 
to  normal  value  of  similar  land  is  taken  as  the  multi- 
plier to  be  used  in  finding  the  reproduction  cost,  the 
land  originally  donated  could  not  be  given  any  value 
as  a  portion  of  the  reproduction  cost.  Such  a  result 
would  be  absurd.  It  makes  no  difference  whether  the 
land  was  donated  or  purchased  by  the  company  as  far 
as  the  reproduction  cost  is  concerned,  unless  it  has  been 
shown  that  the  lands  would  again  be  donated  if  the 
property  were  reproduced.  The  reproduction  cost  is 
what  it  would  cost  the  company  to  acquire  its  existing 
useful  property  at  the  date  of  an  appraisal.  It  was 
to  guard  against  any  such  fallacy  that  the  ascertain- 
ment of  the  trend  of  ratios  in  successive  years  is 
advocated. 

Attention  may  be  called  to  the  practical  advantage 
that  arises  from  the  requirement  of  the  method  above 


advocated  in  which  the  history  and  cost  of  each  parcel 
are  ascertained.  This  detailed  method  of  appraisal 
will  bring  to  light  many  costs  which  a  more  general 
study  would  neglect.  Those  who  have  had  experience 
in  the  construction  of  the  properties  of  public  utilities 
will  recall  many  cases  where  much  necessary  expense 
has  been  incurred  which  would  not  be  shown  as  an 
item  in  an  inventory  and  would  not  be  remembered 
until  recalled  by  a  study  of  past  conditions. 

An  instance  of  this  kind  may  be  cited,  which,  al- 
though not  in  railway  construction,  still  is  similar  to 
many  instances  which  will  be  found  in  the  valuation  of 
railway  property.  This  instance  is  the  expense  which 
is  frequently  incurred  in  the  construction  of  a  reservoir. 
The  land  which  must  be  used  is  occupied  in  part  by 
railways,  highways,  or  other  necessary  public  utilities. 
In  very  many  cases  land  must  be  purchased  elsewhere 
and  the  original  property  reconstructed  in  the  new 
location.  This  new  land  and  all  of  the  replacing  new 
construction  do  not  become  the  property  of  the 
reservoir  company  and,  consequently,  would  not  ap- 
pear in  the  inventory  of  the  physical  plant.  By  the 
method  here  advocated  the  parcel  of  land  acquired 
from  each  utility  will  be  studied  individually  and  the 
original  cost  of  that  parcel  will  be  the  cost  of  the  new 
land  and  all  replacing  construction  plus  any  sums  of 
money  paid  for  the  right  to  make  the  substitution. 

Another  illustration  drawn  from  railroad  experience 
may  be  given.  A  railway  company  in  acquiring  a 
particular  tract  of  land  may  have  blocked  the  usual 
normal  drainage  of  adjacent  lands,  lands  not  owned  by 
it,  and,  as  a  consequence,  may  have  been  obliged  to 
restore  the  draiuage  conditions  by  ditches  built  upon 
property  not  owned  by  it.  By  the  study  of  the  history 
of  each  parcel  these  requirements  as  a  part  of  the  con- 
ditions of  purchase  are  revealed  and  the  cost  of  such 
work,  although  it  be  on  land  foreign  to  the  actual 
holdings  of  the  company,  still  is  a  legitimate  portion  of 
the  cost  to  the  company  of  the  lands  which  it  now  owns. 

The  second  portion  of  both  the  original  cost  and  the 
reproduction  cost  consists  of  all  expenses  not  included 
in  the  price  assigned  as  the  market  price  to  be  paid  by 
the  company  as  a  result  of  condemnation  proceedings. 
The  cost  of  condemnation  proceedings,  and  all  other 
expenses  incident  to  the  purchase  and  recording  of  the 
purchase  of  land,  are  as  much  a  part  of  the  original 
cost  and  of  the  reproduction  cost  of  land  as  are  the 
costs  of  purchasing,  of  transporting,  and  of  placing 
other  items  of  the  physical  property  of  an  undertaking. 
There  should  be  no  controversy  whatever  concerning 
the  right  and  justice  of  including  such  costs  as  a  portion 
of  the  total  original  cost  and  reproduction  cost  of  land. 

While  unquestionably  these  costs  should  be  in- 
cluded,   the   practical   diflficulties   in   ascertaining   all 


80 


THE      UTILITIES      MAGAZINE 


elements  of  cost  which  should  be  included  are  great. 
The  costs  of  condemnation  proceedings,  search  of  titles, 
recording  and  similar  expenses,  are  relatively  easy  to  as- 
certain in  an  accurate  manner.  There  are,  however,  a 
large  number  of  costs  which  are  liable  to  be  overlooked  in 
a  valuation,  cannot  be  allocated  to  any  particular  parcel 
of  land,  or  may  be  so  nearly  on  the  line  between  land 
costs  and  construction  costs  as  to  raise  a  doubt  as  to 
whether  or  not  such  expenses  properly  belong  as  a 
portion  of  the  second  element  of  land  costs.  One 
instance  only  of  such  original  costs  need  be  cited. 

The  original  cost  of  land  at  the  date  of  acquisition 
may  have  been  ascertained  with  all  care.  A  railroad 
company  may  have  elevated  its  tracks  many  years 
after  the  original  dedication  of  its  land  to  railway  pur- 
poses and  in  so  doing  damaged  the  adjacent  property, 
although  the  abutment  may  have  been  constructed 
entirely  upon  the  original  right  of  way  of  the  railroad. 
Clearly  the  damages  which  the  railroad  will  be  obliged 
to  pay  are  a  legitimate  portion  of  the  original  cost  of  the 
land,  but  it  seems  equally  clear  that  such  damages  can 
be  included  more  properly  as  a  portion  of  the  second 
portion  of  the  original  cost  than  of  the  first. 

Unquestionably  there  will  be  many  individual  cases 
where  doubt  will  arise  as  to  whether  incidental  costs 
should  be  made  a  part  of  the  first  or  second  element  of 
original  cost.  In  most  cases  there  should  be  little 
diflBculty  in  properly  allocating  expenses  of  this  charac- 
ter, provided  it  is  remembered  that  the  first  element  is 
designed  to  show  the  difference — if  there  is  any — be- 
tween the  cost  to  the  railroad  at  the  time  it  was  ac- 
quired and  the  prices  paid  by  others  at  that  time 
for  similar  property.  Other  and  later  costs,  if  in- 
cluded with  the  first  element  of  cost,  destroy  the  value 
of  such  figures  as  evidence  of  the  multipliers,  if  any, 
which  can  be  properly  used  in  ascertaining  the  repro- 
duction cost. 

The  full  significance  of  the  method  which  has  been 
described  above  can  possibly  be  best  appreciated  by  an 
outline  of  the  form  which  may  be  used  in  presenting 
figures  designed  to  show  land  values.  Each  parcel 
of  land  will  be  entered  on  such  a  sheet  on  horizontal 
lines  and  the  proper  figures  for  each  parcel  entered  in 
vertical  columns,  headed  as  follows: 

(1)  Description  of  parcel. 

(2)  Date  of  purchase. 

(3)  Area. 

(4)  Market  value  of  adjoining  and  similar  lands  at 
date  of  purchase. 

(5)  Actual  original  cost  in  condemnation  or  by 
private  purchase. 

(6)  Actual  cost  of  acquiring. 

(7)  Total  original  cost. 


(8)  Ratio  of  market  value  at  date  of  purchase  to 
original  cost. 

(9)  Market  value  of  adjoining  similar  lands  at  date 
of  appraisal. 

(10)  Ratio  of  market  value  at  time  of  appraisal  to 
railroad  cost  at  time  of  appraisal. 

(11)  Reproduction  cost. 

Attention  should  be  called  to  two  features  of  this 
method  of  valuing  land,  neither  of  which  can  be  de- 
fined until  all  figures  for  the  land  of  a  railroad  have 
been  found  and  tabulated.  The  first  is  whether  the 
figures  for  different  parcels  of  similar  land  as  shown  by 
column  6  will  not  be  such  as  will  introduce  a  question 
of  doubt  as  to  the  propriety  of  including  them  as  a 
portion  of  one  of  the  figures  used  in  finding  the  proper 
ratio  or  multiplier.  In  other  words,  the  ratios  shown 
in  column  8  should  unquestionably  be  the  relation  of 
the  figures  given  in  column  4  to  those  in  column  5. 
The  question  to  be  ascertained  is  whether  an  error  is 
introduced  when  6  is  added  to  5  to  make  column  7  and 
the  ratio  is  found  by  comparing  4  and  7.  The  doubt 
raised  by  this  question  does  not  affect  the  reliability 
of  the  method.  All  needed  figures  are  presented  in  a 
table  such  as  has  been  outlined  above  and  if  doubt  is 
raised  by  including  "the  cost  of  acquiring  land"  as  a 
portion  of  the  figures  used  in  obtaining  the  multiplier  for 
certain  lands  at  a  particular  date,  they  should  be 
omitted  and  added — either  in  their  original  amount  or 
raised  in  amount  if  such  enhancement  can  be  proved — 
to  the  reproduction  cost  after  that  figure  has  been 
ascertained  by  well  established  multipliers  obtained 
from  ratios  of  columns  4  and  5. 

The  second  feature  to  which  attention  should  be 
called  is  that  the  ratio  given  in  column  10  is  not  neces- 
sarily that  obtained  for  column  8.  It  is  possible  that 
for  similar  lands  the  ratios  given  in  column  8  may  be 
changing  with  the  advance  of  years.  Whether  or  not 
this  is  true  can  be  readily  shown  by  plotting  such  ratios 
in  different  years  as  ordinates  and  abscissae  and  finding 
the  probable  projection  of  the  curves  thus  found  at  the 
date  of  appraisal. 

The  two  features  which  have  just  been  briefly  ex- 
plained are  simple  and  usual,  and  in  practice  would  not 
be  as  compHcated  as  might  appear  from  a  description 
which  does  not  deal  with  actual  figures.  It  is  felt  that 
with  the  data  given  on  land  sheets  such  as  have  been 
advocated  above,  there  could  be  no  question  or  doubt 
raised  as  to  whether  or  not  a  public  utility  was 
obliged  to  pay  more  for  its  land  than  was  usually  the 
case  in  normal  market  transfers  and,  if  so,  by  how  much 
the  normal  market  value  of  adjoining  similar  lands 
should  be  increased  at  the  time  of  appraisal  to  show  the 
true  reproduction  cost  of  the  property. 


LAND      VALUES 


81 


in 

DECISIONS    OF    THE     COURTS    AFFECTING 
LAND  VALUES 

By  pursuing  the  method  previously  described  it  is  be- 
lieved that  the  original  cost  of  land  and  its  cost-new  at 
the  date  of  appraisal  will  have  been  obtained  in  as 
accurate  a  manner  as  possible  and  be  based  on  definite 
and  logical  reasoning.  Objection  will  be  raised  unques- 
tionably to  the  method  outlined  above  on  the  ground 
that  it  is  contrary  to  the  ruling  of  the  Supreme  Court  of 
the  United  States  in  the  Minnesota  rate  case.^  It  is 
imperative,  therefore,  that  the  above  suggested  method 
be  reviewed  in  the  light  of  the  Minnesota  decision, 
keeping  definitely  in  mind  the  fact  that  the  fair  present 
value  of  the  land  as  a  portion  of  the  total  rate  base  is 
not  as  yet  under  discussion  but  simply  the  cost-new  of 
the  land  as  of  the  date  of  its  appraisal. 

If  the  decision  in  the  Minnesota  rate  case  is  studied 
with  the  object  of  ascertaining  the  opinion  of  the  court 
relative  to  figures  purporting  to  show  the  cost-new  to 
the  railroads  of  the  lands  owned  and  used  by  them,  it 
will  be  found  that  objection  was  raised  not  to  the  repro- 
duction cost — the  cost-new  of  the  land — as  evidence  of 
value,  but  rather  to  the  method  which  had  been  em- 
ployed in  obtaining  the  figures  presented  to  the  court 
in  that  particular  case.  On  the  contrary  the  court 
definitely  states: 

"The  cost-of -reproduction  method  is  of  service  in  ascer- 
taining the  present  value  of  the  plant,  when  it  is  reasonably 
applied  and  when  the  cost  of  reproducing  the  property  may 
be  ascertained  with  a  proper  degree  of  certainty"  (p.  452). 

The  method  which  was  used  in  the  Minnesota  Case 
to  derive  the  figures  purporting  to  show  what  it  would 
now  cost  the  railroad  company  to  acquire  its  lands 
must  be  described.  In  that  case  the  fair  market  value 
of  adjacent  and  similarly  situated  lands,  as  of  the  date 
of  appraisal,  was  first  found  and  from  that  as  evidence 
an  arbitrary  estimate  was  made  of  what,  in  the  opinion 
of  the  railroad  company's  land  expert,  the  railroads 
would  have  to  pay.  Note  particularly  that  this  figure 
was  not  the  market  value  of  the  land  in  the  proper 
sense  of  that  term,  but  what  in  the  judgment  of  an 
experienced  railway  official  it  would  cost  the  railroad 
company  to  acquire  the  land.  This  included  an  excess 
which  he  estimated  the  company  would  have  to  pay 
over  the  market  value  of  contiguous  and  similar  prop- 
erty if  a  railroad  were  called  upon  to  undertake  such  a 
reproduction  of  its  right-of-way.  The  figures  thus 
found  did  not,  however,  embrace  an  allowance  for 
payments  which  might  have  to  be  made  for  improve- 
ments that  possibly  might  be  found  upon  the  property 
nor  for  the  consequential  or  severance  damages  which 

'  280  u.  S.  ssie. 
« 


possibly  might  have  to  be  met,  not  for  the  expense  of 
acquisition.  The  supposed  additional  outlays  he  under- 
took to  estimate.  For  this  purpose  he  increased  "the 
'market  value'  as  stated"  {i.  e.,  his  estimate  of  what  the 
railroad  would  have  to  pay),  "  (in  the  case  of  agricultural 
lands  generally  multiplying  it  by  three)  and  thus 
reached  the  amount  set  down  as  the  'value  for  railway 
purposes'  "  (p.  445).  In  the  cases  of  terminal  lands 
the  multiplier  was  smaller. 

The  court  objected  to  figures  derived  in  such  a  man- 
ner and  there  seems  to  be  the  best  reasons  for  feeling 
that  no  fairminded  tribunal  would  hesitate  to  agree 
that  such  a  method  would  produce  figures  which  were 
neither  accurate  nor  convincing. 

The  court  said: 

(a)  "'What  is  termed  the  normal  value  does  not  satis- 
factorily appear"  {p.  450). 

(b)  "It  is  impossible  to  assume,  in  making  a  judicial 
finding  of  what  it  would  cost  to  acquire  the  property,  that 
the  company  would  be  compelled  to  pay  more  than  its  fair 
market  value.  It  is  equipped  with  the  governmental  power 
of  eminent  domain.  In  view  of  its  public  purpose,  it  has 
been  granted  this  privilege  in  order  to  prevent  advantage 
being  taken  of  its  necessities"  {p.  451). 

(c)  "  There  is  no  evidence  before  us  from  which  the  amount 
which  would  properly  be  allowable  in  such  condemnation 
proceedings  can  be  ascertained"  (p.  452). 

(d)  "The  cost-of-reproduction  method  ....  does  not 
justify  the  acceptance  of  results  which  depend  upon  mere 
conjecture"  {p.  452). 

All  of  the  objections  of  the  court  in  the  Minnesota 
Case  are  fully,  definitely,  and  convincingly  met  by  the 
method  which  has  been  presented  above. 

(a)  The  normal  value  of  each  parcel  of  land  at  the 
time  of  its  acquisition  and  at  the  date  of  appraisal 
are  presented  as  evidence.  These  normal  values  are 
established  by  figures  showing  the  prices  paid  at  both 
periods  of  time  for  voluntary  transfers  of  adjacent 
and  similarly  situated  land.  These  figures  may  be 
supplemented  by  expert  opinion  and  checked  by  ratios 
based  on  assessed  values.  The  normal  value  will  be 
satisfactorily  and  convincingly  shown,  if  the  work 
of  the  appraiser  is  properly  and  conscientiously  per- 
formed. 

(b)  The  second  objection  cannot  be  met  in  any  more 
convincing  manner  than  by  the  method  recommended 
above.  The  normal  value  at  the  time  of  acquisition 
of  the  land  is  given  as  well  as  the  actual  cost  to  the 
company.  These  figures  will  show  beyond  mere 
conjecture  whether  or  not,  and  by  how  much,  a  rail- 
road or  any  other  public  utility  company  has  had  to 
pay  in  excess  of  its  normal  value  for  the  land  which 
it  is  using  for  the  public  benefit.  In  such  cases  as  the 
utility  company  had    acquired   its   land   by  eminent 


82 


THE      UTILITIES      MAGAZINE 


domain,  the  cost  assigned  by  the  courts  as  the  fair 
market  value  to  be  paid  by  the  company  is  entered 
in  column  5  as  a  portion  of  the  cost  of  the  land.  In 
other  cases,  where  the  utility  company  has  elected  not 
to  exercise  its  power  of  eminent  domain,  for  the  reason, 
in  most  instances  probably,  that  the  land  could  be 
thus  acquired  more  cheaply,  the  actual  amount  paid 
is  likewise  entered  in  column  5  against  the  parcels 
acquired  in  that  manner. 

Another  feature  possessed  by  the  proposed  method 
must  be  fuUy  appreciated. 

All  conjectural  figures  based  on  claims  for  recogni- 
tion of  special  value  arising  from  the  fact  that  a  com- 
pany owns  and  uses  a  continuous  strip  of  land  for  its 
right  of  way,  or  a  large  area  of  land  for  its  terminal 
purposes,  or  that  its  rights  of  way  and  terminals  are 
peculiarly  well  suited  to  railway  purposes,  or  that 
the  land  was  not  acquired  free  from  encumbrances 
nor  could  be  reproduced  free  from  probably  more 
expensive  encumbrances,  or  similar  claims  for  a  larger 
reproduction  value,  are  entirely  eliminated.  The 
present  value  of  land  derived  by  a  method  which  de- 
mands that  each  of  such  claims  be  given  its  proper 
significance  would  "rest  on  mere  expression  of  judg- 
ment which  finds  no  proper  test  or  standard  in  the 
transactions  of  the  business  world."  But  where  land 
is  taken  by  condemnation  the  laws  are  well  defined 
as  to  what  should  be  included  and  excluded  as  a  portion 
of  the  fair  market  price  to  be  paid  for  the  land  taken. 
The  cost  to  the  company  as  shown  by  the  figures  in 
column  5  include  all  increments  of  value  which  can 
legally  enter  and,  consequently,  the  proposed  method, 
being  based  on  actual  cost  to  the  company,  eliminates 
all  expressions  of  personal  judgment  relative  to  special 
value  which  at  the  time  of  appraisal  could  be  at  best 
but  mere  conjecture. 

Unquestionably  objection  will  be  raised  to  the  above 
treatment  of  the  special  values  inherent  in  a  well  sit- 
uated railway  on  the  ground  that  such  values  must 
have  recognition  in  an  appraisal.  The  answer  to  such 
an  objection  is  clear.  The  present  discussion  is  con- 
cerned simply  with  land  values.  The  adaptability  or 
suitability  for  railroad  purposes  of  the  land  used  by  a 
railroad  does  not  enhance  the  value  of  the  land  beyond 
the  price  assigned  by  the  court  in  condemnation  pro- 
ceedings. The  entire  railroad  property  may  be  bene- 
fited by  special  advantages  in  location,  as  would  be 
shown  by  low  operating  costs,  density  of  traffic,  or 
some  similar  factors  which  may  or  may  not  be  given 
recognition  in  some  other  portion  of  the  appraisal. 
The  cost-new  of  land  is  measured  by  what  the  road 
would  have  to  pay  to  acquire  it  in  condemnation  pro- 
ceedings and  by  nothing  more.  Moreover,  curves 
based  upon  the  diflference  between  the  normal  market 


value  and  the  cost  to  the  company  of  different  classes 
of  land  in  different  years  would  seem  so  convincing, 
to  one  trained  in  their  use,  that  it  is  difficult  to  believe 
that  the  information  derived  in  this  way  would  not 
be  equally  convincing  to  a  court  or  to  a  ratemaking 
tribunal. 

(c)  The  third  objection — that  the  court  had  no  evi- 
dence of  the  cost  to  the  company  of  the  land  obtained  by 
it  through  condemnation  proceedings — is  entirely  re- 
moved by  the  proposed  method,  wherein  the  cost  of  the 
land  obtained  by  condemnation  proceedings  is  pre- 
sented as  a  distinct  figure  separated  from  all  other 
costs  of  acquisition  and  damages,  and  similar  figures 
are  given  where  parcels  have  been  purchased  privately. 
These  figures,  together  with  the  values  of  adjacent  and 
similar  lands  at  the  date  of  the  acquisition  of  the  rail- 
road lands,  establish  a  ratio  that  will  be  irrefutable 
if  the  work  of  the  appraiser  has  been  done  well  and  in 
sufficient  detail. 

(d)  The  fourth  objection — that  the  cost-of-repro- 
duction  method  depends  upon  mere  conjecture  when 
applied  to  land — is  entirely  removed  if  evidence  as 
direct  as  that  afforded  by  the  proposed  method  is 
prepared  and  presented  to  the  court. 

In  concluding  the  discussion  of  the  Minnesota  deci- 
sion as  bearing  upon  the  ascertainment  of  the  repro- 
duction cost  of  land,  one  more  quotation  only  is  neces- 
sary. 

The  court  said: 

"The  conditions  of  ownership  of  the  property  and  the 
amounts  which  would  have  to  be  paid  in  acquiring  the  right- 
of-way,  supposing  the  railroad  to  be  removed,  are  wholly 
beyond   reach   of  any  process   of  rational  determination" 

iV-  452). 

This  statement  would  appear  to  be  a  sweeping  con- 
demnation of  any  method  that  might  be  devised  to 
ascertain  the  reproduction  cost  of  land.  Any  such 
interpretation  would  be  unfair.  If  an  extreme  case  is 
taken  as  an  example  in  which  the  figures  derived  by 
the  above  suggested  method  showed  that  a  railroad 
company  in  every  purchase  that  it  had  made  in  the 
past  had  paid,  as  the  result  of  condemnation  proceed- 
ings, let  us  say,  twice  as  much  as  the  usual  prices 
paid  by  others  for  similarly  situated  adjacent  lands, 
would  a  court  say  that  the  reproduction  cost  would 
not  be  twice  the  normal  market  value  of  similar  lands 
at  the  date  of  the  appraisal?  Clearly  a  fair-minded 
tribunal  could  not  but  hold  that  such  a  ratio  should  be 
used  and  that  the  reproduction  cost  had  been  ascer- 
tained by  a  "process  of  rational  determination."  It 
is  but  a  step  from  such  an  extreme  case  to  practical 
cases  wherein  the  multipliers  for  lands  of  different  char- 
acters have  been  found  carefully  as  above  advocated. 


LAND      VALUES 


83 


The  objection  on  the  part  of  the  court  in  the  Minne- 
sota Case  was  directed  against  the  acceptance  of  repro- 
duction cost,  which  admittedly  depends  upon  hypo- 
thetical considerations,  as  indicating  the  fair  present 
value  of  land — a  value  to  be  made  a  portion  of  the  fair 
rate  base  of  an  entire  property.  This  objection  appears 
to  have  had  particular  weight  in  the  mind  of  the  court 
for  the  reason  that  multipliers — even  when  their  ac- 
curacy has  been  convincingly  proved  —  are  applied 
to  the  normal  market  value  of  adjacent  land,  which 
value  may  have  been  augmented  by  the  existence  and 
operation  of  the  railroad. 

These  objections  are  not  directed  against  reproduc- 
tion cost  as  one  evidence  of  value,  provided  the  repro- 
duction cost  has  been  obtained  in  an  accurate  and 
convincing  manner,  but  rather  against  the  figures 
representing  such  cost  as  showing  the  fair  present 
value  of  the  land  in  a  particular  case. 

This  is  an  entirely  different  question  from  those 
which  have  been  above  discussed  wherein  only  costs 
were  involved. 

IV 

FAIR  PRESENT  VALUE  OF  LAND 

The  fair  present  value  of  a  property — the  fair  basis 
for  rates — is  not  the  reproduction  cost  necessarily  and 
is  not  the  original  cost  necessarily,  but  is  a  fair  figure 
ascertained  for  each  particular  case  when  these  two 
figures,  as  well  as  other  facts  and  figures,  have  been 
properly  found  and  weighed. 

Unquestionably  the  normal  market  price  of  land  has 
been  increased  by  the  growth  of  the  community  due 
largely  in  most  places  to  the  presence  of  the  railroad. 
Unquestionably  also,  if  the  normal  market  price  of 
the  land  is  increased  by  a  well  established  multiplier 
the  reproduction  cost  of  the  land  thus  found  would 
be  large,  but  it  would  show  with  all  reasonable  accu- 
racy what  it  would  cost  to  reproduce  the  land  at  the 
date  of  the  appraisal.  It  would  show  what  it  would 
cost  under  existing  conditions  to  acquire  the  land 
now  used  for  railway  purposes.  It  would  give  a  meas- 
ure of  a  maximum  beyond  which  no  reasonable  claim 
for  a  fair  rate  base  could  be  made.  It  is  this  evidence 
which  is  needful  and  useful  in  every  valuation  even 
though  the  reproduction  cost  of  land  may  never  be 
taken  as  a  portion  of  the  fair  rate  base. 

The  original  cost  is  likewise  evidence  of  the  fair  rate 
base  and  evidence  of  the  same  character  as  reproduction 
cost  even  when  that  latter  cost  is  inflated,  as  that  figure 
appeared  to  the  court  to  be  in  the  Minnesota  case,  by 
the  prosperity  of  the  community  in  which  the  land  is 
situated.  But  the  original  cost  less  depreciation  is, 
in  the  majority  of  cases,  the  minimum,  just  as  the 
reproduction  cost  is  the  maximum  cost,  and  between 


these  two  costs  the  fair  value  must  be  assigned  with 
fair  and  impartial  judgment  in  the  light  of  all  other 
relevant  facts  and  figures. 

The  court  in  the  Minnesota  Case  defined  the  fair 
value  of  the  land  in  the  following  words: 

"Assuming  that  the  company  is  entitled  to  a  reasonable 
share  in  the  general  prosperity  of  the  communities  which 
it  serves,  and  thus  to  attribute  to  its  property  an  increase 
in  value,  still  the  increase  so  allowed,  apart  from  any  im- 
provements it  may  make,  cannot  properly  extend  beyond 
the  fair  average  of  the  normal  market  value  of  land  in 
the  vicinity  having  a  similar  character.  Otherwise  we  enter 
the  realm  of  mere  conjecture.  We  therefore  hold  that  it 
was  error  to  base  the  estimates  of  value  of  the  right-of- 
way,  yards  and  terminals  upon  the  so-called  '  railway  value' 
of  the  property.  The  company  would  certainly  have  no 
ground  of  complaint  if  it  were  allowed  a  value  for  these  lands 
equal  to  the  fair  average  market  value  of  similar  land  in 
the  vicinity,  without  Additions  by  the  use  of  multipliers,  or 
otherwise,  to  cover  hypothetical  outlays  "  (p.  455). 

It  is  seen  that  the  court  took  a  mean  figure  between 
the  reproduction  cost  and  the  original  cost  as  the  fair 
value  of  the  land  in  that  particular  case.  This  decis- 
ion, however,  establishes  no  precedent  whatever 
upon  which  a  contention  can  be  based  that,  in  all  other 
valuations  of  railway  lands,  the  fair  value  that  should 
be  included  in  the  fair  rate  base  must  be  "the  fair 
average  market  value  of  similar  lands  in  the  vicinity. " 
The  above  decision  was  for  a  particular  case  in  which 
possibly  the  increase  in  the  value  of  the  lands 
had  been  very  great.  It  seemed  to  the  court,  in  the 
light  of  all  information  before  it  relative  to  the 
property,  that  such  a  figure  was  just.  It  is  certain  that 
if  the  cost-of-reproduction  of  the  land,  including  all 
elements  of  cost  incident  to  its  acquisition,  was  equal 
to  the  total  original  cost,  other  conditions  remaining  the 
same  as  in  the  case  of  the  Minnesota  railroads,  the 
court  would  not  have  established  the  normal  market 
value  of  adjacent  lands  as  the  value  to  be  assigned 
to  the  lands  as  a  portion  of  the  fair  rate  base  of  the 
entire  property.  It  had  cost  the  company  consider- 
able sums  of  money  to  acquire  the  lands  for  rail- 
road purposes  and  such  costs  are  legitimate  capital 
expenditures.  If  the  value  of  adjacent  similar  lands  in- 
creases with  the  prosperity  of  the  community,the  repro- 
duction cost  will  become  greater  than  the  actual  original 
cost,  but  the  fair  present  value — the  fair  rate  base — 
does  not  necessarily  follow  the  increase  in  reproduction 
cost.  The  fair  present  value  cannot  be  assigned  by 
arbitrary  rules  but  by  well  informed  judgment  in  each 
particular  case. 

Objection  will  be  made  unquestionably  on  the  part 
of  many  public  utility  corporations  to  a  method  of 
ascertaining  fair  present  value  which  necessitates  the 


84 


THE      UTILITIES      MAGAZINE 


use  of  personal  judgment,  and  those  caring  for  corpora- 
tion interests  will  demand  that  the  fair  present  value 
of  land  be  ascertained  and  reported  as  a  portion  of  the 
fair  rate  base.  Furthermore,  it  may  possibly  be 
claimed  that  the  instructions,  given  to  the  Interstate 
Commerce  Commission  in  the  federal  law  requiring 
the  valuation  of  all  railroad  property,  demand  that 
the  fair  value  of  the  railroad  lands  be  found  and 
definitely  assigned  for  the  lands  as  a  whole  or  for  each 
parcel.  In  support  of  this  the  following  words  of  the 
Act  may  be  cited: 

"Second.  Such  investigation  and  report  shall  state  in 
detail  and  separately  from  improvements  the  original  costs 
of  all  lands  ....  and  the  present  value  of  the  same, 
and  separately  the  original  and  present  cost  of  condemna- 
tions and  damages  or  of  purchase  in  excess  of  such  original 
cost  or  present  value. " 

A  careful  study  of  this  portion  of  the  Act  shows  def- 
initely that  the  expression  "present  value"  as  therein 
used  does  not  mean  the  "fair  present  value"  of  the 


lands,  a  value  which  can  be  made  a  portion  of  the 
rate  base  upon  which  a  fair  return  can  be  earned,  but 
rather  the  normal  present  average  market  value  of 
the  lands.  This  value  can  be  obtained  from  the 
value  of  adjacent  similarly  situated  lands  derived  in 
the  manner  described  above. 

The  railroads  and  all  other  public  utility  companies 
must  rely  upon  the  courts  and  rate-making  tribunals 
to  ascertain  the  fair  present  value  of  each  property. 
The  best  interests  of  the  companies,  and  of  the  public 
as  well,  will  be  conserved  by  the  derivation  of  reliable 
and  convincing  figures  which  will  show  without  con- 
jecture what  the  companies'  property  actually  has 
cost,  as  well  as  what  it  would  cost  to  reproduce  the 
same  property  at  the  time  of  an  appraisal. 

The  method,  which  has  been  here  advocated,  elim- 
inates conjecture  and  presents  figures  that  should  be 
convincing.  The  difiiculties  and  expense  involved  in 
obtaining  them  are  admittedly  great,  but  only  in  this 
way  can  proper  evidences  of  the  present  value  of  a 
company's  property  be  obtained. 


LAND   VALUES  UNDER  THE  MINNESOTA  RATE   CASE 

By  Mk.  Thomas  D.  O'Brien 

Counsellor  at  Law,  St.  Paul,  Minn.      {Counsel  jor  Minnesota  in  Minnesota  Rate  Case) 


It  was  supposed,  at  least  by  some,  that  with  the  decision 
of  the  Supreme  Court  in  the  Minnesota  Rate  Cases,  230 
U.  S.  352,  the  impropriety  of  adding  to  the  normal  market 
value  of  lands  "by  the  use  of  multipliers,  or  otherwise,  to 
cover  hypothetical  outlays"  had  been  finally  established. 
Mr.  Hayes,  however,  seems  to  insist  that  the  decision 
amounted  to  no  more  than  a  condemnation  of  the  particular 
method  adopted  by  the  Master  in  those  cases. 

After  expressing  his  concurrence  with  the  conclusion  of 
the  court  in  those  cases,  Mr.  Hayes  points  out  the  distinc- 
tions which,  he  claims,  exist  between  the  methods  rejected 
by  the  court  and  those  now  advanced  by  him.  A  fair 
statement  of  the  position  taken  by  the  learned  gentleman  is 
that: — 

In  determining  land  values  by  ascertaining  cost  of  repro- 
duction (reacquisition),  it  is  allowable  to  find  a  cost  greater 
than  the  normal  present  market  value  of  the  lands. 

I  insist  upon  the  contrary,  under  the  decision  in  the  Minne- 
sota Rate  Cases,  that  while  reproduction  cost  reasonably 
applied,  is  of  service  in  ascertaining  present  value, — the 
cost  of  acquisition  of  land  must  be  taken  to  be  its  normal 
market  value  determined  by  "the  fair  average  market  value 
of  similar  lands  in  the  vicinity,  without  additions  by  the 
use  of  multipliers,  or  otherwise,  to  cover  hypothetical  out- 
lays." 

In  the  Ames  case  (169  U.  S.  54),  the  court,  in  enumerating 
the  elements  to  be  considered  in  arriving  at  a  fair  value. 


gave  amongst  others  "the  present  as  compared  with  the 
original  cost  of  construction."  This  language  is  taken  to 
require  a  finding  of  reproduction  cost,  and  this  again  is 
assumed  to  imply  in  the  case  of  land,  something  more  than 
actual  present  market  value. 

The  Ames  case  did  not  define  the  method  to  be  employed 
in  ascertaining  present  cost,  and  the  complainants  in  the 
Minnesota  case  felt  at  liberty  to  adopt  the  literal  meaning 
of  the  word  "reproduction"  and  assume  the  non-existence 
of  the  railroad,  and  the  necessity  for  its  present  acquisition 
and  construction.  These  assumptions  were  indulged  in  as 
to  land,  and  also  as  to  every  other  item  of  property  consti- 
tuting the  plant. 

It  is  true,  as  pointed  out  by  Mr.  Hayes,  that  there  was  first 
added  to  market  value  an  indefinite  amount  to  find  railway 
value,  and  this  amount  was  again  increased  by  the  use  of 
multipliers,  but  the  fact  that  two  additions  were  made  to 
market  value  was  not  a  controlling  consideration  with  the 
court.  A  reading  of  the  decision  is  entirely  convincing  that 
the  error  condemned  by  the  court  consisted  in  adding  to 
market  value  any  amount  upon  any  conjectural  hypothesis. 

The  proper  method  for  ascertaining  "the  present  cost  of 
construction"  required  by  the  Ames  case,  has  come  before 
the  Supreme  Court  on  several  occasions,  but  as  applied  to 
land  it  would  seem  that  the  last  word  was  written  by  Mr. 
Justice  Hughes  in  the  Minnesota  cases,  and  his  language 
cannot  be  interpreted  to  justify  any  addition  to  market 
value.     A  few  quotations  are  sufficient. 


LAND      VALUES 


85 


"These  are  the  results  of  the  endeavor  to  apply  the  cost  of 
reproduction  method  in  determining  the  value  of  right  of  way. 
It  is  at  once  apparent  that  so  far  as  the  estimate  rests  upon 
a  supposed  compulsory  feature  of  the  acquisition,  it  cannot 

be  sustained "     (Page  430.) 

"moreover,  it  is  manifest  that  an  attempt  to  estimate  what 
would  be  the  actual  cost  of  acquiring  the  right  of  way,  if 
the  railroad  were  not  there,  is  to  indulge  in  mere  speculation 

The  assumption  of  its  non-existence,  and  at  the 

same  time,  that  the  values  that  rest  upon  it  remained  un- 
changed, is  impossible,  and  cannot  be  entertained.  The 
conditions  of  ownership  of  the  property,  and  the  amounts 
which  would  have  to  be  paid  in  acquiring  the  right  of  way, 
supposing  the  railroad  to  be  removed,  are  wholly  beyond 

reach  of  any  process  of  rational  determination 

(Page  452.) 

and  finally; 

"Assuming  that  the  company  is  entitled  to  a  reasonable 
share  in  the  general  prosperity  of  the  communities  which  it 
serves,  and  thus  to  attribute  to  its  property  an  increase  in 
value,  still  the  increase  so  allowed,  apart  from  any  improve- 
ments it  may  make,  cannot  properly  extend  beyond  the  fair 
average  of  the  normal  market  value  of  land  in  the  vicinity 
having  a  similar  character.  Otherwise  we  enter  the  realm 
of  mere  conjecture.  We,  therefore,  hold  that  it  was  error 
to  base  the  estimates  of  value  of  the  right  of  way,  yards, 
and  terminals  upon  the  so-called  railway  value  of  the  prop- 
erty. The  Company  would  certainly  have  no  ground  of 
complaint  if  it  were  allowed  a  value  for  these  lands  equal  to 
the  fair  average  market  value  of  similar  land  in  the  vicinity, 
without  additions  by  the  use  of  multipliers,  or  otherwise. 


to  cover  hypothetical  outlays.  The  allowances  made  below 
for  conjectural  cost  of  acquisition  and  consequential  damages 
must  be  disapproved;     ....      "     (Page  455.) 

It  is  apparent  that  the  objection  of  the  court  was  to  any 
allowance  above  market  value,  and  it  would  seem  that  such 
objection  must  be  persisted  in. 

The  proposed  formulae,  by  its  own  terms,  destroys  its 
utility;  thus  market  value  is  to  be  first  determined,  and  this 
amount  increased  by  a  multiplier.  Such  a  course  necessarily 
results  in  an  allowance  greater  than  market  value;  therefore 
greater  than  real  or  true  value,  greater  than  the  amount 
which  the  Supreme  Court  placed  as  the  limit  which  the 
companies  could  demand. 

If  the  additional  or  extra  amount  secured  by  the  use  of 
this  multiplier  cannot  be  included  in  an  actual  proceeding, 
what  practical  reason  can  be  given  for  its  ascertainment? 
It  proves  nothing,  establishes  nothing.  It  is  an  attempt  to 
give  a  literal  interpretation  to  a  mere  form  of  expression,  and 
to  establish  values  which  have  no  existence  except  in  the 
assumption  itself. 

To  adopt,  in  order  to  value  a  plant,  the  assumption  of  its 
reproduction  is  entirely  reasonable,  if  reasonably  applied. 
In  the  item  "land,"  however,  the  assumption  should  never 
be  used  to  establish  as  "reproduction  cost,"  an  amount 
higher  than  market  value  determined  by  the  value  of  similar 
lands  in  the  vicinity. 


THE  MEASUREMENT  OF  LAND  VALUE 

By  Edward  W.  Doty 

With  The  Columbus  (Ohio)  Railway,  Power  and  Light  Company;  ForTner  Member,  The  Public  Utilities  Commission  of  Ohio 


As  long  as  it  shall  be  deemed  necessary  to  obtain  what  is 
usually  called  the  physical  value  of  railroads  and  utilities, 
there  ought  to  be  some  better  method  of  measuring  that 
part  of  that  value  called  land  value  than  the  rule-of-thumbs 
that  usually  obtains.  It  seems  strange  that  the  improve- 
ment in  making  measurements  of  other  things  should  not 
have  been  accompanied  by  some  more  widespread  improve- 
ment of  measuring  land  value  than  has  yet  made  itself  felt. 
That  land  value  is  not  tangible  is  true,  but  land  is  tangible 
and  its  use  is  well  understood  and  is  measured  in  some 
fashion  by  a  considerable  portion  of  every  community  every 
day. 

Probably  there  is  no  part  of  the  valuation  problem  where 
there  is  such  a  mixture  of  thought  and  expression,  such  a 
misuse  of  terms,  as  there  is  in  the  valuation  of  land.  The 
imderlying  difficulty  appears  to  me  to  be  the  idea,  which 
we  all  possess  to  a  greater  or  less  degree,  that  land  value 
is  a  certain,  definite,  determinable  amount,  or  sum  or  price. 

We  talk  of  "market  value"  of  land  in  cities  as  if  land 
sites,  no  two  of  which  are  or  can  be  alike,  can  be  said  to  have 
"market  value."  We  express  our  judgment  of  land  value  in 
the  price  of  the  square  foot,  when  the  usefulness  of  any 
two  square  feet,  either  in  the  same  site  or  in  two  separate 


sites,  is  scarcely  ever  the  same.  We  attempt  to  compare 
the  value  of  one  site  with  that  of  another,  often  when  no 
factor  of  one  is  duplicated  in  the  other.  We  think  that  it  is 
possible  to  compare  the  value  of  one  site  with  the  value  of 
all  neighboring  sites,  by  a  wave  of  the  hands  and  the  usual 
qualifications  of  an  expert. 

The  cause  for  the  inadequacy  of  land  valuation  as  it  is 
practiced  in  our  courts  and  before  our  commissions  is  the 
absence  of  any  attempt  to  carry  out  the  same  principles 
that  are  employed  in  the  valuation  of  tangible  property. 

In  the  valuation  of  anything  there  must  be  a  recognition 
that  there  are  two  acts  performed:  First,  the  mental  opera- 
tion; second,  the  mathematical  operation.  In  land  valuation 
there  has  been  a  mixture  of  these  two  acts.  Experts  have 
been  solving  only  the  simplest  valuation  problems  by  a 
proper  separation  of  these  acts.  When  problems  that  are 
intricate,  involving  as  most  problems  of  high  values  in  cities 
always  do,  the  presence  of  various  factors  of  value  with 
varying  degrees '  of  effect,  these  experts  usually  ignore 
mathematics  and  combine  the  mental  and  mathematical 
acts.  This  is  the  direct  cause  of  the  wide  discrepancies 
found  in  expert  testimony  touching  land  valuations. 

In  order  to  perform  the  mental  part  of  the  task  of  appraisal 


86 


THE      UTILITIES      MAGAZINE 


easily  and  satisfactorily,  and  in  order  to  perform  the  mathe- 
matical side  of  the  task  at  all,  there  must  be  a  unit  of  quan- 
tity. This  is  exactly  what  is  provided  for  in  the  task  of 
valuing  anything  else,  such  as  the  yard  for  cloth,  the  pound 
for  sugar,  the  ton  for  coal,  the  kw.  for  electric  energy, 
and  so  on.  What  is  absolutely  necessary  for  site  valuation 
is  a  unit  of  quantity  that  will  have  a  proper  basis  for  its 
existence.  Any  unit  of  quantity  must  be  large  enough  to 
be  effective  when  used  and  small  enough  for  the  hupian 
mind  to  grasp.  Land  sites  have  three  factors  that  affect 
their  usefulness  and  therefore  their  value — size,  shape  and 
location.  If  our  unit  of  quantity  undertook  to  include  all 
three  or  any  two  of  these  factors,  there  would  result  the 
same  confusion  that  exists  among  appraisers  now.  Let  us 
assume  a  given  size  and  a  given  shape,  leaving  only  location 
to  be  included  in  any  expression  of  value  or  price.  This 
may  be  done  by  assuming  a  foot  wide  on  the  street  line 
and  100  feet  deep  from  the  street  line,  with  the  side  lines 
at  right  angles.  Let  this  unit  foot  always  be  assumed  to 
come  to  the  street  far  anough  from  a  side  street  to  be  out- 
side of  any  usefulness  traceable  to  that  or  any  other  street, 
except  the  one  street. 

When  this  unit  of  quantity  is  used  by  any  two  persons, 
any  expression  of  value  thereof  is  easily  understood  by  both 
and  any  differences  of  opinion  between  the  two  would  be 
traceable  only  to  differences  as  to  the  value  of  location. 
This  would  base  land  valuation  in  cities  upon  the  opinion 
of  the  value  of  the  usefulness  of  the  streets  and  other  means 
of  accessibility.  This  method  opens  up  a  very  wide  source 
of  information  and  opinion  for  there  are  many  more  people 
in  any  community  who  know  more  about  the  relative  useful- 
ness, and  therefore  the  relation  of  value,  of  their  streets, 
than  there  are  who  know  about  the  value  of  specific  lots 
or  sites.  And  after  all  it  is  the  valuation  of  the  streets  that 
is  of  prime  importance;  one  street  is  more  useful,  or  more 
attractive,  or  nearer  some  business  center  or  some  park, 
than  is  another,  and  there  is  usually  a  well  defined  difference 
of  opinion  in  the  community  as  to  the  effect  of  those  differ- 
ences. 

The  attempt  to  base  land  valuations  upon  sales  is  one  of 
the  most  ridiculous  things  that  we  talk  about.  I  say, 
ridiculous,  because  no  one  ever  actually  uses  a  sale  for  any 
conclusive  valuation.  The  reasons  for  this  are  many  and 
are  really  very  obvious.  Usually  there  is  no  sale  anywhere 
near  the  property  to  be  appraised — this  is  especially  so  in 
high  priced  districts  in  our  larger  cities.  When  there  is  a 
sale  its  terms  are  usually  not  known;  and  when  they  are 
known  it  is  often  found  that  there  are  some  conditions  that 
would  affect  the  cash  price.  And  if  there  is  found  a  sale,  at 
a  fair  price,  and  the  terms  all  public,  it  is  then  always  found 
that  the  factors  affecting  the  value  of  the  property  used  as 
the  standard  and  the  factors  of  the  property  to  be  compared 
and  therefore  valued,  differ  so  materially  that  no  comparison 
can  be  easily  and  therefore  effectively  made.  If  one  will 
go  over  the  testimony  of  experts  who  are  attempting  to  value 
high  priced  city  sites,  such  as  are  found  in  cities  like  Philadel- 
phia, New  York,  Chicago,  Cleveland  and  other  places,  it 
Tvill  be  found  that  there  is  absolutely  little  or  no  relation 


between  sales  and  the  valuation  given.  Different  experts 
will  bring  in  quite  different  results  from  the  sales,  assuming 
they  use  sales  figures  at  all. 

An  appraisal  a  year  or  two  ago,  made  for  the  purpose  of 
condemnation,  of  the  block  in  New  York  City  bounded  by 
Pearl,  Lafayette,  Worth  and  Centre  streets,  illustrates  what 
happens  when  the  opinion  of  experts  is  depended  upon  for  a 
valuation.  There  were  six  expert  land  appraisers  who 
undertook  to  give  opinion  as  to  the  value  of  the  various 
plots  that  went  to  make  up  this  block.  I  insert  here  a 
diagram  of  this  block  showing  the  shapes  of  the  fifteen  lots, 
no  two  of  which  are  alike;  these  lots  are  numbered.  The 
appraisers  will  be  designated  by  the  letters  B,  D,  G,  K, 
P  and  R.  The  various  estimates  of  value  set  forth  were 
made  by  these  six  expert  appraisers.  It  is  interesting  to 
compare  the  figures  with  the  diagram  that  goes  with  them. 
It  is  an  exhibit  of  what  we  are  accustomed  to  when  listen- 
ing to  testimony  based  as  it  usually  is,  upon  the  rule-of- 
thumbs  method  of  making  a  valuation. 


^^^P^ 


^T 


2     3 


31 


^ 

^ 


28 

29 

21 

20 

\ 

19 

)(8 

F 

23 

22 

18  \ 

" 

\ 

WOGTH-  J$T. 


Lot  No. 

1 

2  to  5 

6 

8 
18 
19 
20 

21-29 
23 
25 
26 
27 
28 


"B" 

$115,500 

173,000 

155,000 

1,000 

40,000 

34,000 

30,000 

120,500 

48,000 

49,000 

31,000 

33,000 

29,000 


"D" 

$174,060 

305,635 

170,000 

3,000 

94,100 

58,240 

41,500 

99,160 

64,150 

60,000 

43,750 

41,215 

35,200 


•■G" 

$120,000 

190,000 

160,000 

5,000 

47,000 

47,000 

33,000 

96,000 

50,000 

40,000 

28,000 

25,000 

26,000 


"K" 

$130,000 

185,000 

152,500 

5,000 

37,000 

40,000 

31,000 

104,000 

55,000 

40,000 

27,500 

27,000 

26,000 


..p.. 

$105,000 

145,996 

121,400 

5,000 

32,832 

40,754 


98,464 
53,609 
40,672 
27,880 
28,240 
27,518 


"R" 

$106,500 

274,500 

150,000 

2,890 

69,600 

57,000 

40,550 

101,650 

67,500 

43,935 

33,000 

32,250 

30,000 


It  is  very  evident  from  the  foregoing  results  that  these 
appraisers  used  different  standards  for  the  basis  of  their 


LAND      VALUES 


87 


opinion.  What  those  standards  were  was  never  disclosed. 
If  they  had  been  taught  to  appraise  the  value  of  the  streets 
and  had  known  how  to  apply  that  valuation  to  the  sites 
contiguous  to  the  streets,  there  would  not  have  been  the 
wide  variations;  indeed,  any  variations  would  have  been 
traceable  to  a  difference  of  opinion  as  to  the  valuation  of  the 
streets  and  would  not  include  differences  not  only  of  the 
value  of  the  streets,  but  also  of  the  amount  of  the  street 
value  that  may  be  said  to  be  absorbed  by  each  of  the  lots 
that  go  to  make  up  this  block.  There  may  well  be  a  differ- 
ence of  opinion  as  to  quaUty  but  there  ought  not  to  be  any 
difference  of  opinion  as  to  the  mathematics  that  may  be 
necessary  to  translate  the  effect  of  that  quality  when  ex- 


The  figures  in  the  streets  are  the  prices  of  the  unit  foot  for 
each  block.  The  dotted  lines  in  the  blocks  of  the  terminal 
(those  bounded  by  the  heavy  black  lines)  show  the  areas 
that  are  affected  by  the  various  streets  or  combination  of 
streets.  The  value  of  each  section  and  of  the  whole  terminal 
will  be  found  in  the  area  set  apart  for  Penn  Square. 

It  will  be  observed  that  in  making  this  appraisal  the 
judgment  of  land  value  was  exercised  over  an  area  from 
Chestnut  Street  on  the  south  to  Arch  Street  on  the  north 
and  from  Penn  Square  to  the  river,  nearly  five  times  the 
area  that  was  actually  to  be  appraised.  It  is  apparent  that 
the  value  of  any  lot  in  this  area  could  be  computed  and 
compared  with  the  value  of  any  other  lot  either  computed 


PROPERTY  or  THE  PENNSYLVANIA  RAILHOAD  COMPANY 

5MOWINC  METHOD  or  CALCULATING  APPRAISCD  VALUCS, 


1_. 


1400  1600 


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1      "6     \ 


MARKET  SXUCCT 


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30 

1400 


1400 

1520 


J!  Tin;  fin?  > 


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4000    4750    6000 


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APPIMSE0VALUE5 

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♦dANUTACTURCRS' APPRAOAL   COMPANY     CLt VCLAND,Oi-UO, 
By  ffW  .90MC5?  uNiT  -svaTCM  or  reautv  valuaiion 


pressed  in  terms  of  price  per  unit  of  quantity,  into  a  total 
value,  just  as  is  done  a  million  times  a  day  as  to  the  value 
of  other  things. 

I  am  not  going  into  the  intricacies  of  the  Somers  System, 
which  is  the  mathematics  of  the  appraisal  of  land  sites; 
suffice  it  to  say  that  the  system  has  been  used  in  the  land 
appraisal  of  more  than  thirty  American  cities,  it  has  been 
used  in  Ohio  for  the  valuation  of  land  sites  for  public  utilities, 
and  is  the  only  method  that  I  know  of  that  answers  every 
demand  of  a  system  not  only  as  to  the  easy  problems  of 
the  appraisal,  but  the  intricate  and  complicated  problems- 
as  well. 

An  illustration  of  the  use  of  the  system  is  the  appraisal 
of  the  land  value  of  the  site  occupied  by  the  Pennsylvania 
railroad  company  in  Philadelphia,  known  as  the  Broad 
Street  Terminal.  The  figures  are  based  upon  opinion  in 
the  summer  of  1913,  but  probably  there  has  not  been  any 
very  great  change  since  then.  I  append  the  map  of  this 
terminal,  running  from  Penn  Square  to  the  Schuylkill  River. 


or  known  in  some  other  way.  This  is  the  only  method  of 
comparing  the  city  sites  to  be  appraised  with  the  value 
of  neighboring  and  contiguous  lands,  that  has  ever  been 
devised. 

Whether  this  valuation  meets  the  approval  of  any  one  in 
Philadelphia  or  not,  is  not  the  important  question;  the 
important  question  is:  Is  this  an  analysis  that  gives  due 
weight  to  every  factor  that  affects  the  value  of  this  termi- 
nal? I  would  say  in  passing  that  this  appraisal  has  been 
public  property  for  about  two  years,  and  thus  far  no  one 
has  successfully  challenged  the  valuation  made. 

The  difference  between  these  two  appraisals  is  the  difference 
between  an  a,nalysis  upon  a  secret  and  ill-defined  basis,  and 
an  analysis  upon  an  open,  public  and  well  defined  basis; 
between  the  rule-of -thumbs  and  the  rule  of  mathematics; 
between  an  attempt  at  impossible  mental  act  and  a  sub- 
stitution therefor  of  the  natural  and  consequently  effective 
method  that  comes  from  a  proper  appreciation  of  what  the 
human  mind  was  built  for  and  how  it  works. 


88 


THE      UTILITIES      MAGAZINE 


PRINCIPLES  TO  BE  APPLIED  IN  VALUATION  OF  LANDS  USED  FOR  THE  PURPOSE 

OF  A   COMMON   CARRIER 

By  a.  E.  Helm 

Commerce  Counsel,  Public  Utilities  Commission  of  Kansas 


It  is  not  my  purpose  to  discuss  the  methods  which  shall 
be  adopted  or  used  in  collecting  and  stating  the  facts  re- 
quired to  be  ascertained  to  comply  with  the  requirements 
of  the  Act  which  commands  the  Interstate  Commerce  Com- 
mission to  make  a  valuation  of  railroad  properties.  These 
are  questions  for  the  consideration  of  engineers  and  account- 
ants. I  agree  with  the  representatives  of  the  carriers  that 
the  various  cost  figures  mentioned  in  the  Act  should  be 
classified  and  reported  in  the  fullest  detail.  It  is  not  with 
the  collection  of  these  cost  items  that  I  am  concerned,  but 
rather  as  to  the  use  which  shall  be  made  of  the  figures  in 
determining  the  proper  rate  base  to  be  used  in  rate  cases. 

PROVISIONS  OF  THE  VALUATION  ACT 

The  first  part  of  Section  19a  of  the  Act  directs  the  Inter- 
state Commerce  Commission,  as  therein  provided. 

"To  investigate,  ascertain  and  report  the  value  of  all  the 
property  owned  or  used  by  every  common  carrier  subject 
to  the  Act." 

The  second  paragraph  of  the  Section  provides  that 

"such  investigation  and  report  shall  state  in  detail  and 
separately  from  improvements  the  original  cost  of  all  lands, 
rights  of  way,  and  terminals  owned  or  used  for  the  purposes 
of  a  common  carrier,  and  ascertained  as  of  the  time  of  dedica- 
tion to  public  use,  and  the  present  value  of  the  same,  and 
separately  the  original  and  present  cost  of  condemnation 
and  damages  or  of  purchase  in  excess  of  such  original  cost 
or  present  value." 

My  remarks  will  be  confined  to  the  question  as  to  what 
consideration  should  be  given  in  rate  cases  to  the  present 
value  of  railroad  rights  of  way  and  terminals,  so  far  as  such 
present  value  is  in  excess  of  original  cost. 

THE  CARRIERS'  CONTENTION 

The  carriers  are  contending  that  the  Commission  shall 
investigate  and  rejwrt  the  present  value  of  all  lands  used 
for  the  purposes  of  a  common  carrier  as  a  part  of  the  cost  of 
reproduction  new  and  that  such  present  value  shall  be 
determined  by  ascertaining  the  present  market  value  per 
unit  of  area,  of  the  tract  of  land  out  of  which  each  particular 
piece  of  railroad  land  was  taken,  as  a  basis  for  fixing  the 
normal  present  value  per  unit  of  area  of  each  such  particular 
piece  of  railroad  land.  This  so-called  normal  value  is  to  be 
increased  by  a  multiple  of  two  and  one  half  or  three  to  cover 
the  excess  cost  over  the  normal  value  of  lands  of  similar  char- 
acter in  the  same  vicinity  which  it  is  claimed  experience  shows 
that  railroads  are  required  to  pay  for  their  rights  of  way, 
etc.  To  the  amount  thus  ascertained  it  is  proposed  to  add 
a  further  sum  to  cover  the  increased  value  of  the  lands  for 
railroad  use  arising  merely  from  the  connection  of  the 
several  parts. 


The  total  value  of  railroad  lands  so  determined  considered 
in  connection  with  other  items  of  cost  of  reproduction  new 
is  proposed  to  be  used  as  the  chief  basis  for  ascertaining  the 
"fair  value"  mentioned  by  the  courts  for  rate  making  pur- 
poses. 

It  is  apparent  to  every  one  in  this  conference  what  the 
effect  will  be  upon  railroad  rates  and  upon  the  commerce 
of  the  country  if  this  program  of  the  carriers  is  allowed  to 
be  carried  out  in  all  its  details. 

RAILROADS  ARE  PUBLIC  HIGHWAYS 

The  determination  of  the  principles  which  should  be 
applied  in  ascertaining  the  just  and  equitable  value  of  lands 
used  for  the  purpose  of  a  common  carrier  requires  a  consid- 
eration of  the  nature  of  the  property  to  be  valued  and  the 
purpose  for  which  the  value  is  to  be  used. 

In  the  first  place,  it  should  be  understood  that  the  rail- 
roads are  public  highways,  dedicated  to  the  public  use. 
The  companies  operating  and  managing  them  are  not  the 
private  owners  of  the  railroads.  The  proprietary  rights 
remain  in  the  state.  Those  who  manage  and  supervise  their 
use  are  public  agents,  charged  with  the  duty  of  performing 
a  service  for  the  public.  To  admit  the  existence  of  any  other 
relation  would  be  to  deny  the  public  character  of  these  roads. 
There  cannot  be  private  property  in  the  lands  used  for  a 
right  of  way,  any  more  than  there  can  be  private  property 
in  a  navigable  waterway,  a  country  road,  a  city  street,  or 
any  other  highway  or  thoroughfare  of  commerce  and  travel. 
This  proposition  was  never  more  earnestly  asserted  or 
clearly  demonstrated  by  anyone  than  by  one  of  Pennsyl- 
vania's most  able  and  distinguished  jurists  and  statesmen — 
the  late  Jeremiah  S.  Black.  In  a  speech  delivered  before 
the  Judiciary  Committee  of  the  Pennsylvania  Senate  at  the 
Session  of  1883,  Judge  Black  said: 

"It  will,  I  think,  be  admitted  by  all  impartial  persons  of 
average  intelligence,  that  the  companies  are  not  the  owners 
of  the  railroads.  The  notion  that  they  are  is  as  silly  as  it 
is  pernicious.  It  is  the  duty  of  every  commercial,  manufac- 
turing or  agricultural  state  to  open  thoroughfares  of  trade 
and  travel  through  her  territory.  For  that  purpose  she  may 
take  the  property  of  citizens  and  pay  for  the  work  out  of  her 
own  treasury.  When  it  is  done  she  may  make  it  free  to  all 
comers,  or  she  may  reimburse  the  cost  of  levying  a  special 
tax  upon  those  who  use  it,  or  she  may  get  the  road  built  and 
opened  by  a  corporation  or  an  individual  and  pay  for  it  by 
permitting  the  builder  to  collect  tolls  or  taxes  from  those 
who  carry  and  travel  on  it.  Pennsylvania  has  tried  all  these 
methods  with  her  turnpike,  canals  and  railroads  .  .  .  . 
but  in  all  these  cases  the  proprietary  rights  remained  in  the 
State  and  were  held  by  her  in  trust  for  the  use  of  the  people. 
Those  who  run  the  railroads  and  canals  are  always  public 
agents.  It  is  impossible  to  look  at  them  in  any  other  light, 
or  to  conceive  how  a  different  relation  could  exist  because  a 
railroad  which  is  not  managed  by  public  agents  cannot  be 
a  public  highway. " 


LAND      VALUES 


Judge  Black  further  called  attention  to  the  decision  of 
the  Supreme  Court  of  Pennsylvania  in  the  case  of  the  Erie 
and  N.  E.  R.  R.  Co.  vs.  Casey,  where  he  points  out  that 

"It  was  determined  that  a  railroad  built  by  authority  of 
the  state  for  the  general  purposes  of  commerce  is  a  public 
highway  and  in  no  sense  private  propertj';  that  a  corporation 
authorized  to  run  it  is  a  servant  of  the  state  as  much  as  an 
officer  legally  appointed  to  do  any  other  public  duty;  as 
strictly  confined  to  the  laws  and  as  liable  to  be  removed  for 
transgressing  them." 

The  same  principle  has  been  universally  recognized  by  all 
of  the  state  and  federal  courts  where  the  right  of  the  state 
to  vote  bonds  and  levy  taxes  to  pay  the  same  in  aid  of  the 
construction  of  railroads  has  been  considered.  No  authority 
can  be  found  in  any  constitution  for  voting  public  aid  to  a 
private  business,  and  no  court  has  ever  upheld  the  authority 
to  do  so. 

It  is  true  that  courts  have  frequently  used  language 
which  might  seem  to  indicate  that  they  were  inclined  to 
hold  that  railroad  corporations  are  the  owners  of  the  road- 
bed and  transportation  facilities  used  by  them  in  the  trans- 
action of  their  business  as  a  common  carrier.  Wherever 
such  expressions  have  been  used  by  the  court  it  will  be  found 
that  the  question  as  to  the  nature  of  the  ownership  of  the 
railroads  was  not  material  and  not  directly  involved  in  the 
case  under  consideration. 

On  the  other  hand,  no  case  can  be  found  where  the  courts 
have  expressly  denied  the  public  character  of  the  railroads. 
The  right  of  the  state  to  grant  to  railroads  the  power  of 
eminent  domain,  to  make  grants  of  public  lands  to  them,  to 
vote  bonds  and  aid  of  various  kinds,  on  account  of  their 
public  character,  has  been  everywhere  admitted.  The  right 
of  the  government  to  regulate  their  business  is  no  longer 
denied.  This  regulation  extends  to  the  service  performed, 
the  charges  assessed  for  the  service,  and  the  maintenance 
of  the  roadbed  and  equipment,  so  as  to  secure  the  safety  of 
the  public  in  the  operation  and  use  of  the  railroads.  In  case 
of  the  abandonment  of  any  portion  of  the  right  of  way,  it 
reverts  the  same  as  other  abandoned  highways.  The  right 
of  the  government  itself  to  take  over  these  public  highways 
and  operate  them  in  the  interest  of  the  public,  by  paying  to 
the  companies  just  compensation  for  the  rights  and  privi- 
leges which  they  have  in  them,  is  universally  admitted,  and 
the  expediency  of  doing  so  has  been  frequently  discussed  in 
recent  years.  No  railroad  has  the  right  to  tear  up  its  tracks 
and  discontinue  its  business  of  a  common  carrier  without 
the  consent  of  the  state.  In  case  a  railroad,  by  reason  of 
mismanagement,  or  for  other  reasons,  becomes  incapable 
of  meeting  its  financial  obligations,  the  courts  of  the  country 
take  charge  of  the  property  and  operate  it  through  receivers 
for  the  benefit  of  the  public.  No  matter  what  the  company's 
financial  needs  may  be,  it  is  not  allowed  to  disregard  its 
obligations  to  the  public. 

The  act  of  Congress  that  requires  the  valuation  of  the 
railroads  recognizes  that  the  lands  constituting  the  rights  of 
way  and  terminals  are  not  private  property,  but  that  they 
are  dedicated  to  public  use. 

There  can  be  no  question  as  to  the  soundness  of  these 
principles.     The    railroads    are    public    highways;  all    pro- 


prietary rights  in  the  lands  used  as  rights  of  way  and  termi- 
nals are  vested  in  the  state.  It  follows  that  such  lands 
cannot  be  made  the  subject  of  private  speculation  by  the 
public  agents  that  have  been  authorized  by  the  state  to 
operate  these  public  highways. 

If  these  propositions  are  true,  no  allowance  can  be  made 
by  courts  or  commissions  for  the  unearned  increment  of 
value  over  and  above  the  original  cost  of  rights  of  way  and 
terminal  lands  in  fixing  a  basis  upon  which  to  compute  a 
fair  rate  of  return  out  of  rates  on  the  railroad  property 
devoted  to  the  public  use. 

DECISIONS  OF  THE  COURTS 

I  am  aware  that  attorneys  for  the  railroads  contend  vigor- 
ously that  this  matter  has  been  settled  by  the  Supreme 
Court  of  the  United  States  against  the  proposition  which  I 
am  here  asserting,  and  they  point  to  numerous  decisions  of 
that  great  tribunal,  which  they  claim  supports  their  conten- 
tion. 

Among  these  decisions  are  the  following: 


Regan  vs.  Farmers  Loan  &  Trust  Co.,  154  U.  S. 

Smythe  vs.  Ames,  169  U.  S.  466; 

San  Diego  Land  &  Town  Co.  vs.  National  City,  174  U.  S.  7,S9; 

San  Diego  Land  <fc  Town  Co.  vs.  Jasper,  189  U.  S.  439; 

Stanislaus  County  vs.  San  Joaquin  &  Kings  River  Canal  & 

Irrigation  Co.,  192  U.  S.  201; 
Interstate  Commerce  Commission  vs.  Chicago  Great  Western 

Ry.  Co.,  209  U.  S.  108; 
City  of  Knoxville  vs.  Knoxville  Water  Co.,  212  U.  S.  1; 
Wilcox  et  al.  vs.  Consolidated  Gas  Co.,  212  U.  S.  19; 
Minnesota  Rate  Case,  230  U.  S.  352; 
Northern  Pacific  Ry.  Co.  vs.  State  of  North  Dakota,  U.  S. 

Supreme  Court,  decided  March  8,  1915; 
Norfolk  &  Western  Ry.  vs.  Conley,   U.  S.  Supreme   Court, 

decided  March  8,  1915; 
Des  Moines  Gas  Co.  vs.  Des  Moines,  U.  S.  Supreme  Court, 

decided  June  14,  1915. 

An  examination  of  the  cases  will  disclose  the  fact  that 
the  court  has  expressly  refrained  from  laying  down  any  gen- 
eral rule  by  which  to  test  the  reasonableness  of  rates  or  the 
principles  to  be  applied  uniformly  in  all  cases.  On  the 
contrary,  the  court  has  repeatedly  said  that  the  question 
should  be  determined  upon  the  facts  of  each  individual  case. 

In  the  Reagan  case  there  was  no  question  as  to  the  value 
of  unearned  increment  in  land.  The  case  was  decided  upon 
admitted  facts  which  showed  that  the  road  has  never  paid 
any  dividends  on  the  money  actually  invested  in  the  stocks 
of  the  road  and  had  not  paid  the  full  amount  of  interest 
due  on  the  bonds.  The  court  held  that  rates  which  did 
not  produce  any  returns  upon  the  actual  investment  in  the 
railroad  properly  made  by  the  stockholders  were  unreason- 
able and  could  not  be  enforced. 

In  the  leading  case  of  Smythe  vs.  Ames  the  Supreme  Court 
of  the  United  States  enumerated  a  number  of  facts  which 
should  be  considered  in  arriving  at  a  proper  value  of  railroad 
property  as  a  basis  for  fixing  rates.  The  fourteenth  para- 
graph of  the  syllabus  which  expresses  the  views  of  the  court 
upon  this  matter,  is  as  follows: 

"To  ascertain  the  valu.e  of  railroad  property,  the  cost  of 
construction  and  improvements,  the  amount  and  value  of 


90 


THE      UTILITIES      MAGAZINE 


its  bonds   and   stock,   its  earning   capacity   and   operating 
expenses,  are  to  be  considered." 

Nothing  was  said  directly  by  the  court  in  this  case  concern- 
ing the  unearned  increment  of  land,  and  that  question  was 
not  involved. 

The  case  of  San  Diego  Land  &  Town  Company  vs.  National 
City  involved  the  question  of  the  reasonableness  of  water 
rates.  The  specific  question  as  to  what  consideration  should 
be  given  to  the  value  of  the  unearned  increment  in  lands  was 
not  considered. 

The  case  of  San  Diego  Land  &  Town  Company  vs.  Jasper 
was  also  a  case  in  which  the  reasonableness  of  rates  fixing 
prices  for  water  rights  was  considered.  No  question  of  the 
value  to  be  placed  upon  unearned  increment  in  lands  was 
before  the  court. 

The  case  of  Stanislaus  County  vs.  San  Joaquin  and  Kings 
River  Canal  and  Irrigation  Company  was  another  irrigation 
case,  and  the  court  again  stated  the  principle  which  it  had 
announced  in  the  two  San  Diego  Land  Company  cases,  to 
the  effect  that  rates  should  be  fixed  upon  a  basis  which  would 
"under  all  the  circumstances  be  just  to  the  company  and 
to  the  public." 

In  the  case  of  Interstate  Commerce  Commission  vs.  Chicago 
Great  Western  Railway  Company  the  court  considered  the 
validity  of  an  order  of  the  Interstate  Commerce  Commission 
finding  that  there  was  a  discrimination  in  the  rates  charged 
by  the  railroad  upon  livestock  as  compared  with  the  rates 
upon  dressed  meats.  No  question  of  the  value  of  the  prop- 
erty of  the  railroads  was  before  the  court  and  no  decision 
upon  that  question  was  made. 

The  case  of  City  of  Knoxville  vs.  KnoxviUe  Water  Company 
was  a  water  rate  cage.  No  question  as  to  land  value  was 
considered  and  what  the  court  there  said  concerning  valua- 
tion of  tangible  property  had  reference  to  the  depreciated 
tangible  property  of  the  water  works  company. 

The  case  of  Wilcox  et  al.  vs.  Consolidated  Gas  Company 
considers  only  the  question  of  regulating  the  rates  for  the 
sale  of  gas  in  the  city  of  New  York  by  proper  rate  making 
authorities.  The  only  land  referred  to  was  that  upon  which 
the  plant  of  the  company  is  situated.  In  passing  upon  the 
question,  Mr.  Justice  Peckham  says: 

"And  we  concur  with  the  court  below  in  holding  that  the 
value  of  the  property  is  to  be  determined  as  of  the  time 
when  the  inquiry  is  made  regarding  the  rates.  If  the  prop- 
erty, which  legally  enters  into  the  consideration  of  the  ques- 
tion of  rates,  has  increased  in  the  value  since  it  was  acquired, 
the  company  is  entitled  to  the  benefit  of  such  increase. 
That  is,  at  any  rate,  the  general  rule.  We  do  not  say  that 
there  may  not  possibly  be  an  exception  to  it,  where  the 
property  may  have  increased  so  enormously  in  value  as  to 
render  a  rate  permitting  a  reasonable  return  upon  such 
increased  value  unjust  to  the  public.  How  such  fact  should 
be  treated  is  not  a  question  now  before  us,  as  this  case  does 
not  present  it.  We  refer  to  the  matter  only  for  the  purpose 
of  stating  that  the  decision  herein  does  not  prevent  an 
inquiry  into  the  question  when,  if  ever,  it  should  necessarily 
be  presented. " 

The  court  here  clearly  saw  the  danger  of  applying  the 
general  rule  claimed  by  the  carriers  without  exceptions. 
It  will  be  noted  that  Justice  Peckham  points  out  that  it 


is  the  property  which  "legally  enters  into  the  consideration 
of  the  question  of  rates"  which  is  entitled  to  the  benefit  of 
such  increase. 

Again,  the  court  expressly  refrained  from  passing  upon 
the  question  in  a  case  "where  the  property  may  have  in- 
creased so  enormously  in  value  as  to  render  a  rate  permitting 
a  reasonable  return  upon  such  increased  value  unjust  to 
the  public."  That  question  was  left  open  to  be  considered, 
"when,  if  ever,  it  should  necessarily  be  presented." 

We  believe  the  time  has  now  come  when  it  is  necessary 
to  consider  it. 

In  the  Minnesota  Rate  case  the  Supreme  Court  condemned 
the  valuation  approved  by  the  master  in  that  case,  which 
included  an  allowance  for  the  value  of  lands  over  and  above 
the  investment  therein,  and  also  over  and  above  the  market 
value  of  lands  in  the  vicinity  having  similar  character.  In 
passing  upon  this  feature  of  the  case,  Mr.  Justice  Hughes 
said: 

"The  increase  sought  for  'railway  value'  in  these  cases  is 
an  increment  over  all  outlays  of  the  carrier  and  over  the 
value  of  similar  land  in  the  vicinity.  It  is  an  increment 
which  cannot  be  referred  to  any  known  criterion,  but  must 
rest  on  a  mere  expression  of  judgment  which  finds  no  proper 
test  or  standard  in  the  transactions  of  the  business  world. 
It  is  an  increment  which  in  the  last  analysis  must  rest  on 
an  estimate  of  the  value  of  the  railroad  use  as  compared 
with  other  business  uses;  it  involves  an  appreciation  of  the 
returns  from  rates  (when  rates  themselves  are  in  dispute) 
and  a  sweeping  generalization  embracing  substantially  all 
the  activities  of  the  community.  For  an  allowance  of  this 
character  there  is  no  warrant." 

This  decision  does  not  recognize  the  right  of  carriers 
to  earn  a  return  upon  the  unearned  increment  in  the 
lands  used  by  them  for  rights  of  way  and  terminals. 
On  the  contrary,  so  far  as  it  speaks  upon  that  question,  it 
most  emphatically  disapproves  any  such  allowance. 

In  the  case  of  the  Northern  Pacific  Railway  Company  vs. 
State  of  North  Dakota,  decided  March  8,  1915,  the  court 
decided  but  one  question — that  a  railroad  company  has  a 
right  to  earn  a  profit  upon  each  service  rendered.  No 
question  of  the  values  of  land  or  even  the  value  of  the  rail- 
road property  itself  was  considered. 

In  the  case  of  Norfolk  &  Western  Railway  Company  vs. 
Conley,  decided  March  8,  1915,  the  legislature  of  West  Vir- 
ginia had  established  a  two-cent  passenger  rate  in  that  state. 
The  actual  expenses  of  the  plaintiff  for  carrying  on  its  passen- 
ger traffic  operating  under  this  law  for  the  years  1908  and 
1909  were  $1,552  greater  than  its  receipts  for  that  traffic, 
and  the  court  held  that  such  a  law  was  unconstitutional 
and  specifically  said  in  its  opinion  that  it  was  not  necessary 
to  determine  the  value  of  the  property  devoted  to  that 
traffic,  and  no  value  of  any  of  the  property  was  considered 
by  the  court. 

In  the  Des  Moines  Gas  Company  case  the  Supreme  Court 
upheld  the  master  in  his  finding  "that  there  was  neither 
justice  nor  equity  in  requiring  the  people  who  had  been  at 
the  expense  of  paving  the  streets  to  pay  an  additional  sum 
for  gas  because  the  plant  when  put  in  would  have  to  be  at 
the  expense  of  taking  up  and  replacing  the  pavements  in 
building  the  same." 


LAND      VALUES 


91 


The  master  also  held  that  such  added  value  was  wholly 
theoretical  when  no  benefit  was  derived  therefrom,  which 
holding  was  upheld  by  the  Supreme  Court. 

None  of  the  above  cases,  nor  any  others  to  which  my 
attention  has  been  called,  support  the  claim  of  the  carriers 
that  the  courts  have  held  that  the  unearned  increment  in 
land  used  for  railroad  right  of  way  and  terminals  is  to  be 
added  to  the  cost  value  for  rate  making  purposes. 

As  was  said  by  Mr.  Justice  Hughes  in  the  Minnesota  Case: 

"It  is  manifest  that  an  attempt  to  estimate  what  would 
be  the  actual  cost  of  acquiring  the  right  of  way,  if  the  railroad 
were  not  there,  is  to  indulge  in  mere  speculation.  The  rail- 
road has  long  been  established;  to  it  have  been  linked  the 
activities  of  agriculture,  industry  and  trade.  Communities 
have  long  been  dependent  upon  its  service,  and  their  growth 
and  development  have  been  conditions  upon  the  facilities 
it  has  provided.  The  uses  of  property  in  the  communities 
which  it  serves  are  to  a  large  degree  determined  by  it.  The 
values  of  the  property  along  its  line  largely  depend  upon 
its  existence.  It  is  an  integral  part  of  the  communal  life. 
The  assumption  of  its  non-existence,  and  at  the  same  time 
that  the  values  that  rest  upon  it  remain  unchanged,  is  im- 


possible and  can  not  be  entertained.  The  conditions  of 
ownership  of  the  property  and  the  amounts  which  would 
have  to  be  paid  in  acquiring  the  right  of  way,  supposing 
the  railroad  to  be  removed,  are  wholly  beyond  reach  of  any 
process  of  rational  determination." 

CONCLUSION 

Everyone  must  admit  that  the  increment  in  land  values 
which  comes  by  reason  of  the  development  of  the  country 
and  the  activities  of  the  people  living  in  its  vicinity  is  created 
entirely  by  the  people  themselves,  and  if  such  increase  in 
value  is  to  be  used  as  a  reason  for  increasing  freight  charges, 
it  follows  logically  that  the  more  the  people  contribute  to 
the  value  of  the  railroads,  the  more  they  should  be  required 
to  pay  for  the  service  rendered  by  these  transportation 
companies. 

If  the  courts  have  sanctioned  any  such  a  doctrine  as  this 
it  is  time  for  them  to  recede  from  it,  otherwise  the  people 
through  their  lawmaking  power  will  soon  direct  the  courts 
as  to  what  are  their  constitutional  limitations  in  the  matter 
of  making  rates,  which  is  clearly  a  legislative  function. 


DISCUSSION 

Hon.  John  M.  Eshleman 
Former  President  of  California  Railroad  Commission 


I  am  not  scheduled  to  be  on  the  program  in  this  discussion. 
I  have  been  asked  to  say  a  word  or  two.  I  could  disagree 
quite  successfully  both  with  the  views  of  Mr.  Hayes  and 
Judge  Helm,  but  there  is  no  time  now  to  state  my  views, 
and  I  would  not  disagree  so  substantially  from  the  results, 
particularly  those  of  Judge  Helm.  I,  however,  want  to  say 
now  that  there  is  a  danger  in  this  agency  theory,  and  a  very 
great  danger  from  the  standpoint  of  public  regulation.  The 
California  Commission  ran  up  against  that  danger,  and, 
while  the  theory  that  we  advocate  brings  about  a  very 
similar  result,  still  we  rejected  the  agency  theory  officially 
while  I  was  on  the  Commission  of  California. 

Briefly,  that  danger  is  this :  We  have  utilities  that  are  newer 
than  railroads.  There  was  a  time  when  a  gas  company  was 
not  a  utility;  there  was  another  time  when  electrical  com- 
panies were  not  utilities;  there  was  still  another  time  when 
a  telephone  company  was  not  a  utility;  and  there  was 
another  time  when  an  irrigation  company  was  not  a  utility. 
The  Supreme  Court  of  the  State  of  California  held  in  a  well- 
contested  case  that  we  have  been  trying  to  get  them  to 
overrule  ever  since,  that  in  effect  what  an  agency  said  about 
its  property  determined  its  status,  not  what  it  actually  did. 
The  Supreme  Court  of  the  United  States  in  the  Stanislaus 
Water  case  practically  sustained  that  position.  In  other 
words,  an  irrigation  company  down  in  the  southern  end  of 
the  state,  entered  into  an  arrangement  whereby  it  sold  water 
only  to  those  with  whom  it  made  contracts  and  it  determined 
the  contracts  in  advance.  Five  hundred  thousand  acres  of 
desert  land  and  50,000  people,  seven  or  eight  cities,  one  of 
them  of  7,000  people,  are  all  dependent  upon  this  particular 


water  company  and  it  is  not  subject  to  any  regulation  in  the 
slightest  degree.  That  may  be  startling.  That  is  the  fact 
in  California,  because  of  this  very  agency  theory,  because 
you  cannot  take  a  man's  property  against  his  will,  and 
where  you  have  an  agency  there  must  be  some  dedication, 
so  the  Supreme  Court  of  California  says,  on  the  part  of  the 
agent  in  control  of  the  property;  that  is  some  voluntary 
giving.  Therefore  as  to  railroads  and  all  of  these  others 
that  have  done  things  that  constitute  a  dedication,  there  is 
no  danger,  but  for  the  future,  you  can  take  the  decision  of 
the  Supreme  Court  of  California  in  the  Thayer  case,  and 
under  it,  relieve  an  electrical  company,  for  example,  for  all 
time  from  regulation.  I  cannot  go  into  this  in  detail,  but 
suffice  it  to  say,  if  the  creation  of  an  agency  requires  the 
voluntary  assent  to  the  burden  of  the  agency  by  the  one 
creating  it,  then  the  agency  theory  will  always  carry  the 
danger  with  it,  to  which  I  have  referred  when  we  are  deal- 
ing with  public  utilities.  The  theory  I  have  advocated  and 
that  the  California  Commission  has  adopted  will  produce  the 
same  result  without  the  danger. 

As  far  as  lands  are  concerned  it  seems  to  me  we  have 
entirely  overlooked  some  very  important  legal  considera- 
tions. There  is  a  servitude  upon  railroad  lands  and  upon 
railroad  property,  not  brought  on  by  reason  of  the  relation- 
ship of  agency,  but  there  is  a  servitude  existing  that  absor 
lutely  prevents  the  same  canons  of  valuation  applying  as 
apply  in  competitive  industry.  I  will  illustrate  thus.  You 
give  to  the  railroad  and  the  other  utilities  alike  the  power 
of  eminent  domain.  They  come  along  to  me — I  have  a 
piece  of  land  that  I  want  to  keep.     I  want  to  get  the  un- 


92 


THE      UTILITIES      MAGAZINE 


earned  increment  in  that  land.  The  railroad  wants  it  and 
because  it  performs  a  public  function  it  has  a  right  to 
take  it  away  from  me  against  my  will.  On  what  theory 
and  on  what  terms?  One  alone:  That  it  will  devote  it  to 
one  specific  use.  Isn't  that  true.'  Not  to  warehouses, 
not  to  residences;  not  to  anything  but  railroad  business. 
Isn't  that  true?  If  I  have  a  piece  of  land  here,  and  Professor 
Gray  has  another  piece  alongside  of  it,  absolutely  the  same 
kind  of  land,  the  same  size,  the  same  character  of  soil,  and 
I  can  only  use  mine  for  one  purpose  and  he  can  use  his 
for  all  purposes,  which  one  woidd  you  buy  if  you  had  your 
option?  Now  ponder  that  proposition.  The  fact  that  these 
agencies  have  to  use  their  property  for  but  one  purpose  puts 
what  in  law,  as  in  fact,  is.  a  servitude  upon  those  properties 
and  prevents  them  from  being  of  the  same  value  as  adjoin- 
ing properties.  You  cannot  say  that  because  the  adjoining 
properties  are  of  a  certain  value  for  warehouse  purposes  the 
railroad  property  is  of  the  same  value  for  the  same  purpose, 
because  it  cannot  be  used  for  that  purpose.  In  this  you  have 
to  segregate  carefully  between  operative  and  non-operative 
properties.  As  to  non-operative  property,  oil  lands,  agri- 
cultural lands,  timber  lands  and  the  like,  there  is  no  servi- 
tude, and  the  same  rules  with  reference  to  value  apply  to 
those  lands  that  apply  to  all  other  lands,  but  not  so  to 
railroad  rights  of -way,  and  terminals  and  other  operative 
property.  This  property  is  given  to  them  as  it  were  with  a 
string  to  it,  on  the  promise  that  they  will  only  use  it  for 
railroad  purposes.  That  is  a  suflBcient  servitude,  at  least, 
to  make  a  difference  in  the  value.  In  my  opinion  it  takes 
away  from  them  the  right  to  the  unearned  increment,  and 
it  would  be  absolutely  unjust  to  the  former  owner  if  that 
were  not  true,  because  you  have  no  right  to  come  along 
and  take  my  land  away  from  me,  which  I  want  to  keep 
absolutely  against  my  will,  on  the  promise  to  devote  it  to 
one  specific  purpose  and  then  get  the  beneficial  results  that 
would  flow  from  using  it  for  all  purposes,  forgetting  the 
limitation.  That  point  is  worth  considering.  I  made  it 
three  years  ago.  I  believe  it  now  as  strongly  as  I  did 
then.  That  is  one  of  the  reasons  that  I  believe  the  land 
question  is  not  being  solved  right  and  that  it  is  not 
necessary  to  resort  to  your  theories  of  agency  and  it  is  not 
necessary  to  resort  to  anything  except  commonly  known  and 


accepted  principles  and  economic  laws,  because  that  prop- 
erty can  only  be  used  for  one  purpose  and  it  is  not  as 
valuable  as  similar  property  that  can  be  used  for  all 
purposes. 

The  paper  by  Mr.  Hayes  presents  that  aspect  of  the 
case  very  clearly.  But  I  have  never  been  able  to  see  why 
it  is  any  more  logical  to  take  the  case  where  the  property 
has  been  condemned  and  a  higher  price  paid  as  tj'pical, 
rather  than  to  take  the  piece  of  land  that  was  not  con- 
demned but  was  given.  How  is  it  logical  to  find  the 
highest  that  was  paid  for  property  and  use  that  as 
typical?  It  seems  to  me  it  would  be  just  as  logical  in 
taking  one  half  the  way  down  or  taking  the  lowest  price. 
To  be  consistent  you  would  have  to  assume  that  all  of 
the  land  had  to  be  condemned  and  that  you  had  to  pay 
more  than  it  was  worth.  I  do  not  quarrel  at  all  with  the 
suggestion  of  Mr.  Hayes  that  you  pay  or  that  you  let  the 
railroad  have  what  it  actually  had  to  pay,  at  the  time  of 
the  taking  even  though  excessive.  This  does  not  have  any 
bearing  on  the  theory  that  I  am  advancing.  If  they  paid 
a  certain  amount  all  right,  but  that  does  not  mean  that 
what  was  given  to  them  should  have  the  same  rule  applied 
to  it.  I  want  to  suggest  that  on  land  values  we  do  not 
as  yet  have  to  resort  to  the  excellent  scheme  that  Mr. 
Maltbie  is  going  to  present  to  you,  I  am  sure,  because 
we  all  understand  it — it  is  very  excellent — and  we  may  have 
to  resort  to  it  finally.  I  think  on  legal  principles  you  can 
make  even  a  court  understand  that  there  is  a  servitude 
upon  these  lands  that  prevents  these  lands  from  taking 
the  coiu-se  in  valuation — absolutely  impossible  for  them 
to  do  it — that  adjoining  lands  take.  It  is  useless  to  say 
that  the  railroad  land  is  of  the  same  value  as  adjoining 
land  which  is  used  for  warehouse  purposes,  when  the  railroad 
land  never  can  be  used  for  warehouse  purposes.  It  is 
equally  foolish  to  say  that  it  is  of  the  same  value  as  adjoining 
land  for  farm  purposes  when  the  railroad  right  of  way  never 
can  be  used  for  farm  purposes  and  was  acquired  on  the 
promise,  and  on  the  promise  alone,  that  it  never  would  be 
used  for  those  purposes.  Anyone  in  analyzing  that  situation 
will  have  to  conclude  that  there  is  at  least  a  servitude  on 
these  lands  sufficiently  important  in  character  as  to  have  a 
material  effect  upon  the  value. 


DISCUSSION  OF  PRINCIPLES  TO  BE  APPLIED  IN  VALUING  LAND 

By  F.  W.  Stevens 

General  Valuation  Countd,  New  York  Central  Lines;  formerly  Chairman,  Public  Service  Crnnmistion,  Sd  District,  New  York 


The  thing  which  has  attracted  my  attention,  and  my 
very  serious  attention,  in  this  conference  is  the  utter  dis- 
regard that  is  paid  by  very  many  serious  and  thoughtful 
gentlemen  to  the  law  of  the  land.  I  say  that  in  view  of  the 
fact  that  this  conference  was  undoubtedly  called  in  view 
of  the  pending  valuation  of  railroad  property,  the  greatest 
valuation  that  ever  took  place  or  probably  ever  will  take 


place  and  that  as  practical  men  we  should  devote  ourselves 
to  the  serious  consideration  of  that  problem.  Now  the 
Act  of  Congress  requires  that  the  value  of  all  lands  owned 
or  used  by  any  railroad  company  for  its  purposes  as  a  com- 
mon carrier  must  be  valued.  There  is  no  getting  away 
from  that  proposition.  And  the  Act  of  Congress  also 
recognizes  with  perfect  distinctness  that  there  is  a  difference 


LAND      VALUES 


93 


between  cost  and  value.  That  distinction  has  been  in  the 
Act  from  the  very  day  of  its  enactment  and  has  been  so 
recognized  by  the  Interstate  Commerce  Commission  itself 
as  well  as  by  the  world  at  large.  In  addition  to  that,  the 
Supreme  Court  of  the  United  States  in  unmistakable 
language  and  times,  I  might  say,  without  number — although 
they  can  be  counted  up — has  put  upon  the  value  of  the 
property  used  the  burden  of  being  the  basis  for  all  rates. 
The  Supreme  Court  of  the  United  States  laid  that  rule 
down  in  1898,  nearly  eighteen  years  ago,  and  has  consistently 
and  uniformly  repeated  it  in  every  decision  which  it  has 
made  since  upon  the  subject,  in  precisely  the  language  which 
it  used  in  1898.  Now  what  did  it  mean?  That  is  the  first 
question. 

I  take  it  that  in  a  republican  government  the  only  safety 
that  we  have  for  our  public  institutions  is  to  observe  and 
obey  the  law.  If  any  man  thinks  the  law  is  wrong,  it  is 
absolutely  his  right,  if  not  his  duty,  to  try  to  change  it  in  the 
proper  legal  and  constitutional  manner.  But  I  do  insist  that 
it  is  the  duty  of  the  Interstate  Commerce  Commission  to 
obey  the  law  as  it  stands,  and  we  know  that  the  final  word 
as  to  the  law  of  the  land  is  in  the  United  States  Supreme 
Court.    We  cannot  and  we  should  not  disregard  it. 

There  is  a  great  difference  of  opinion  as  to  what  the 
Supreme  Court  of  the  United  States  meant  by  the  word 
"value."  There  is  not  the  slightest  ground  for  argument  upon 
that  question — ^not  the  slightest;  and  in  order  to  reach  that 
question  I  propose  to  call  your  attention  to  the  circumstances 
that  led  up  to  the  use  of  that  language.  It  was  not  decided 
until  about  the  year  1877  that  legislatures  or  their  creatures, 
commissions,  had  the  power  to  regulate  rates  for  public 
service  corporations.  That  proposition  was  laid  down  first 
in  the  Munn  case  and  five  succeeding  granger  cases  decided 
at  the  same  time,  and  in  deciding  it  the  court  used  language 
that  many  interpreted  to  mean  that  the  decision  of  the 
question  of  what  the  rate  should  be  lay  absolutely  with  the 
legislature.  The  matter  ran  along  and  kept  coming  before 
the  court  until  finally  about  1884 — not  to  give  you  the 
names  of  all  the  cases — in  an  opinion  by  Chief  Justice  Waite, 
who  wrote  the  opinion  in  the  Munn  case:  he  said,  it  must 
not  be  understood  that  there  was  no  limitation  upon  this 
power  of  the  legislature  to  prescribe  rates,  but  that  they 
must  be  subject  to  the  constitutional  provision  that  no 
person  should  be  deprived  of  his  property  without  just 
compensation  or  of  the  equal  protection  of  the  laws.  The 
matter  then  ran  along  until  the  Milwaukee  case  in  1889, 
when  the  court  finally  and  definitely  decided  that  the 
legislature  had  no  power  to  create  a  rate  which  was  confisca- 
tory in  its  character,  which  denied  to  the  owner  of  that 
property  just  compensation  for  its  use  and  which  denied 
to  him  the  equal  protection  of  the  laws.  And  from  that 
day  to  this  it  has  stood  as  the  law  of  the  land  that  the  final 
word,  not  upon  the  reasonableness  of  the  rate,  but  upon  the 
question  of  whether  the  property  of  the  carrier  was  confis- 
cated, lay  with  the  courts  and  not  with  the  legislatures  or 
Congress.  Immediately  after  that  there  commenced  to  come 
before  the  Supreme  Court  cases  in  which,  according  to  the 
judgment  of  the  court,  there  had  been  gross  confiscation  of 


the  property  of  the  carriers  or  attempted  gross  confiscation, 
by  the  legislatures  of  several  states.  It  is  not  my  language 
that  it  was  confiscation;  it  is  the  language  of  the  Supreme 
Court.  There  were  no  less  than  five  such  cases  between 
1893  and  1897,  when  the  Smythe  case  came  before  the  United 
States  Supreme  Court  in  which  the  court  set  aside  the 
rates  established  by  the  legislatures  of  the  several  states 
upon  the  ground  that  they  were  confiscatory,  so  that  the 
court  was  fully  familiar  with  the  questions  in  this  class  of 
cases.  It  had  had  its  attention  repeatedly  called  to  every 
question  of  what  constituted  confiscation.  But  up  to  the 
time  of  Smythe  v.  Ames  they  never  had  laid  down  any  rule 
whatsoever  by  which  it  was  to  be  determined.  The  cases 
did  not  call  for  it.  The  case  of  Smythe  v.  Ames  did  call  for 
the  laying  down  of  a  rule.  They  appreciated  it  and  fully 
understood  it.  They  reviewed — Justice  Harlan  in  his 
opinion — reviewed  the  principal  cases  which  the  court 
had  decided  in  the  then  past  four  or  five  years  and  pointed 
out  that  there  must  be  a  substantial  rule  by  which  it  could 
be  determined  whether  or  not  property  was  confiscated.  At 
that  time  it  repudiated  the  idea  that  it  had  any  power  to 
fix  rates  or  makes  rates,  and  it  has  repudiated  that  power 
in  practically  every  expression  it  has  since  made.  It  has 
said  time  and  time  again  that  its  power  was  simply  to 
prevent  confiscation,  the  taking  away  of  property  without 
just  compensation,  so  that  they  were  attempting  to  lay  down 
a  rule  to  prevent  confiscation.  And  the  word  which  they 
used  was  "value."  It  has  been  read  here  so  many  times 
that  it  is  entirely  unnecessary  for  me  to  repeat  it.  What 
did  they  mean  by  it? 

Up  to  that  time  there  never  had  been  a  suggestion  that  I 
have  seen  or  heard  of  as  to  what  the  word  "value"  meant 
when  expressed  in  terms  of  money,  except  the  one  thing, 
the  power  to  command  other  commodities  or  other  property, 
what  is  usually  termed  exchange  value.  The  Supreme 
Court  in  half  a  dozen  cases,  the  very  members  of  the  court 
who  sat  in  Smythe  v.  Ames,  had  in  the  strongest  language  pro- 
claimed that.  It  was  the  definition  of  every  economist  who 
had  written,  upon  the  subject,  and  every  standard  work  upon 
economic  matters  that  had  been  published  up  to  that  time 
said  it.  Many  courts  in  the  United  States  had  said  it  and 
it  had  been  defined  repeatedly.  Many  courts  in  the  United 
States  had  declared  that  value  meant  that  when  applied 
to  economic  questions.  There  was  absolutely  no  question 
about  it,  as  to  the  meaning  at  that  time,  and  the  strongest 
definition,  the  strongest  language  regarding  that  came  from 
the  Supreme  Court  itseK.  So  that  we  know  what  the  men 
before  Smythe  vs.  Ames  used  the  word  for;  we  know  what 
the  Supreme  Court,  the  precise  individuals, — ^not  what  the 
mythical  entity  the  court  had  spoken  forty  or  fifty  years 
before, — but  the  precise  individuals  who  constituted  the 
court  had  declared  it  meant.  That  is  what  it  meant.  It 
declared  that  the  basis  was  the  fair  value.  What  did  the 
word  "fair"  mean?  Somebody  thinks  it  means  something 
different  from  exchange  value.     What  is  it? 

I  want  to  read  to  you  from  some  of  the  expressions  of  the 
court.  I  will  call  your  attention  to  the  language  of  Mr. 
Justice  Brewer,  who  was  one  of  the  judges  of  the  court 


94 


THE      UTILITIES      MAGAZINE 


who  decided  Smythe  vs.  Ames  and  whose  decision  in  the 
Circuit  Court  was  affirmed.  In  the  Circuit  Court  Mr. 
Brewer  said:  "What  is  the  test  by  which  reasonableness 
of  rates  is  determined.''  It  is  not  yet  fully  settled."  "Now 
if  the  public  was  seeking  to  take  title  to  the  railroad  by 
condemnation,  the  present  value  of  the  property  and  not 
the  cost  is  that  which  it  would  have  to  pay.  In  like  manner 
it  may  be  argued  that  when  the  legislature  assumes  the 
right  to  reduce,  the  rates  so  reduced  cannot  be  adjudged 
unreasonable  if  under  them  there  is  earned  by  the  railroad 
company  a  fair  interest  on  the  actual  value  of  the  property." 
I  am  reading  this  to  show  you  what  Justice  Brewer,  who 
helped  decide  Smythe  vs.  Am^s,  thought  about  value.  He 
said  further: 

"Property  invested  in  railroads  is  as  much  protected 
from  public  appropriation  as  any  other.  If  taken  for 
public  uses  its  value  must  be  paid  for.  Constitutional  guaran- 
ties, to  this  extent,  are  explicit,  and  in  such  condemnation 
proceedings  no  inquiry  is  permitted  as  to  how  the  owners 
have  acquired  the  property,  provided  only  it  be  legally 
held  by  them.  If  a  farm  belongs  to  an  individual,  and 
the  public  seeks  to  take  it,  it  must  pay  its  value,  and  is  not 
permitted  to  diminish  the  price  by  proving  that  the  owner 
acquired  the  means  to  purchase  it  by  immoral  or  disreputa- 
ble practices.  He  may  have  made  a  fortune  dealing  in 
slaves,  as  a  lobbyist  or  in  any  other  way  obnoxious  to  the 
public,  but  if  he  has  acquired  the  legal  title  to  the  property, 
he  is  protected  in  its  possession  and  cannot  be  disturbed 
until  the  receipt  of  its  actual  cash  value.  The  same  rule 
controls  if  railroad  property  is  sought  to  be  appropriated. 
No  inquiry  is  permitted  as  to  whether  the  owner  has  received 
gifts  from  the  state  or  individuals  or  whether  it  has,  as 
owner,  managed  the  property  well  or  ill  so  as  to  acquire  a 
large  fortune  therefrom.  It  is  enough  that  he  owns  the 
property,  has  the  legal  title,  and  so  owning,  he  must  be 
paid  the  actual  value  of  the  property.  If  he  has  done 
any  wrong  at  any  time  in  acquiring  or  using  the  property, 
that  wrong  must  be  redressed  in  a  direct  action  therefor  and 
cannot  be  made  a  factor  in  condemnation  proceedings. 
These  propositions  in  respect  to  condemnation  proceedings 
are  so  well  settled  that  no  one  ever  questions  them. 

"The  same  general  ideas  must  enter  into  and  control 
legislation  of  the  kind  before  us.  The  value  of  property 
cannot  be  destroyed  by  the  legislature  depriving  the  owner 
of  adequate  compensation." 

I  think  I  may  say,  without  fear  of  contradiction  successful 
or  otherwise,  that  up  to  this  point  no  one  wiU  dispute  my 
contention.  If  I  am  right  in  it,  the  Supreme  Court  must 
have  changed  the  meaning  of  the  word  "value"  since  the 
case  of  Smythe  vs.  Ames.  That  raises  the  question  whether 
it  has  changed  the  meaning  of  the  word,  and  whether  it  has, 
as  a  part  of  its  judicial  function,  the  power  to  change  the 
meaning  of  a  well-settled  term  in  the  English  language;  and  it 
also  raises  the  question  whether  it  attempts  to  do  so.  I  say 
it  has  not;  and  in  order  to  prove  my  contention  on  that 
point  I  am  going  to  read  you  what  the  court  has  said.  There 
have  been  some  nine  cases  since  the  decision  of  Smythe  vs. 
Ames  in  which  the  court  has  reaffirmed  that  rule.  In  the 
first  one,  in  response  to  the  contention  of  counsel  they  say: 
"The  basis  of  the  calculation  suggested  by  the  appellant  is, 
however,  defective  in  not  requiring  the  real  value  of  the 
property  and  the  fair  value  in  themselves  of  the  services 


rendered  to  be  taken  into  consideration.  What  the  company 
is  entitled  to  demand  in  order  that  it  may  have  just  compen- 
sation is  a  fair  return  upon  the  reasonable  value  of  the 
property  at  the  time  it  is  being  used  for  the  public." 

I  want  to  call  your  attention  to  the  fact  that  when  you 
stand  upon  the  investment,  that  is,  the  cash  paid  out  for 
the  property,  you  do  not  stand  upon  the  property  at  all. 
You  do  not  take  it  into  consideration.  The  property  that 
is  invested  in  a  railroad,  the  money,  was  destroyed.  It 
was  fluid,  floating,  personal  property;  it  was  converted  into 
real  property.  It  was  destroyed  entirely  in  the  process  of 
creating  something  else,  and  the  contention  is  that  you 
are  not  to  respect  the  value  of  the  property  which  has  been 
created,  but  the  property  which  created  it — ^a  very  vast  dis- 
tinction, as  you  will  see  directly. 

The  next  case  is  in  1903,  in  which  the  court  expressly 
decided  that  the  price  of  the  property  involved  concerning 
which  the  rates  were  to  be  fixed,  which  it  brought  into 
public  sale,  determined  its  value — ^not  what  it  cost  to  con- 
struct it,  but  what  it  sold  for  at  public  sale.  The  court 
answered  the  contention  that  such  price  was  not  the  fair 
value  of  the  property  by  saying, 

"The  officers  of  the  two  companies  at  the  time  thought 
that  they  got  more  than  they  could  have  got  in  any  other 
way.  But  at  all  events,  it  is  decided  that  the  price  is  evi- 
dence— we  might  say  more  important  evidence — than  the 
original  cost.  If  the  supervisors  were  convinced  by  it,  we 
could  not  say  as  a  matter  of  law  that  they  were  wrong." 

There  they  decided  that  price  was  evidence  of  value. 
But  what  further  did  they  say.''  I  quote  this  simply  to  see 
whether  the  court  has  changed  its  idea  of  value. 

"Of  course  it  is  hard  to  answer  the  proposition,  that  value 
expressed  in  money  depends  upon  what  people  think  at  the 
time.  That  determines  what  they  will  give  for  the  thing, 
and  whether  they  think  right  or  wrong,  if  they  or  some 
one  will  give  a  certain  price  for  it,  that  is  its  value  then." 

That  was  said  in  1903. 

The  next  case,  in  1912,  was  a  case  where  the  court  said 
that  "if  the  property  had  increased  in  value  since  it  was 
acquired,  the  company  was  entitled  to  the  benefit  of  such 
increase."  The  cost  had  not  increased.  Such  is  the  general 
rule. 

Mb.  Eshleman:  That  the  court  left  open  for  decision, 
but  it  should  be  presented  in  proper  cases. 

Mr.  Stevens:  I  know  very  well  what  you  have  in  mind. 
The  court  has  spoken  several  times  since,  and  the  last 
utterance  is  the  most  decisive  of  all.  Then  we  come  down 
to  1913.  The  court  said  on  this  subject— I  am  simply 
showing  what  they  now  understand  value  to  mean,  be- 
cause it  has  been  charged  that  the  court  is  shifting  its 
ground  and  it  was  represented  to  the  committee  of  the 
Senate  in  Congress  that  it  was  shifting  around,  stepping  out 
in  the  dark,  to  find  out  something  about  values.  But  the 
court  said  in  1913 — speaking  of  a  rate  case  in  a  railroad 
matter — "It  is  clear  that  in  ascertaining  present  value  we 
are  not  limited  to  the  consideration  of  the  amount  of  the 
actual  investment.  As  the  company  may  not  be  protected 
in   its  actual  investment  if  the  value  of  its  property  be 


LAND      VALUES 


95 


plainly  less,  so  the  making  of  a  just  return  for  the  use  of 
the  property  involves  the  recognition  of  its  fair  value  if  it 
be  more  than  its  cost.  The  property  is  held  in  private 
ownership,  and  it  is  that  property  and  not  the  original  cost 
of  it,  of  which  the  owner  may  not  be  deprived  without 
due  process  of  law."     Has  the  Supreme  Court  shifted.'' 

The  next  case  was  a  California  case — I  presume  my  friend 
Eshleman  is  entirely  familiar  with  it — San  Joaquin  Co.  vs. 
Stanislaus  County.  Now  we  are  getting  down  to  rock 
bottom.  A  certain  school  of  thinkers  say  first  that  a  rail- 
road company  is  not  entitled  to  have  considered  in  its  valua- 
tion of  property,  in  making  rates,  property  which  has  been 
donated  to  it,  because  there  was  no  cost;  second,  that  it  is 
not  entitled  to  have  considered  that  property  which  it  paid 
for  out  of  earnings  or  from  surplus,  because  that  indicated 
the  fact  that  it  treated  the  public  unjustly,  and  that  such 
earnings  were  in  excess  of  reasonable  returns  and  therefore 
should  not  be  counted  the  second  time  against  the  public; 
and  third,  that  it  is  not  entitled  to  any  return  upon  the 
special  franchise  which  it  owns,  all  because  it  did  not  pay 
for  it.     That  is  the  contention. 

That  question  came  up  precisely  in  the  last  case  before 
the  United  States  Supreme  Court  (233  U.  S.),  and  in 
that  case  a  case  of  fixing  rates — the  company  claimed 
that  there  should  be  valued  in  its  property  for  rate  making 
purposes  certain  water  rights.  They  were  not  riparian  pro- 
prietors, but  they  were  taking  water  from  a  public  stream, 
a  stream  which  was  declared  by  the  constitution  of  California 
to  be  a  public  use.  The  master  in  chancery  held  that  the 
value  of  those  water  rights  was  a  million  dollars;  but  he 
held  that  the  company  was  not  entitled  to  have  them  con- 
sidered in  making  rates,  because  they  were  not  the  owners 
of  them,  principally  because  they  had  not  paid  anything 
for  them.  The  company  contended  it  had  paid  something 
for  them.  Circuit  Judge  Morrow,  in  the  Circuit  Court, 
stood  with  the  master  and  held  practically  that  they  were 
not  the  owners  of  those  water  rights.  Upon  that  question 
alone  the  case  went  to  the  Supreme  Court  of  the  United 
States.  The  court  stated  the  issue  before  it  to  be  a  very 
narrow  one.     I  will  use  the  language : 

"The  bill  concerns  rates  fixed  in  1907  and  the  question 
before  the  court  has  been  narrowed  to  the  single  issue: 
If  the  plaintiff  is  entitled  to  six  per  cent  upon  its  tangible 
property  alone,  it  is  agreed  that  the  orders  must  stand, 
but  if  the  plaintiff  has  water  rights  that  are  to  be  taken 
into  account,  the  rates  fixed  will  fall  short  of  giving  it  what 
it  is  entitled  to     ...     .     and  must  be  set  aside." 

There  is  a  straight  question  as  to  whether  original  cost 
was  to  be  the  basis  of  value.  The  court  disposed  of  the 
question  in  two  sentences: 

"It  is  not  disputed  that  plaintiff  has  a  right,  as  against 
riparian  proprietors,  to  withdraw  the  water  that  it  distrib- 
utes through  its  canals.  Whether  the  right  was  paid  for  as 
plaintiff"  says,  or  not,  it  has  been  confirmed  by  prescription 
and  is  now  beyond  attack." 

Now,  gentlemen  are  claiming  that  value  means  something 
besides  that.  If  so,  it  has  got  a  definition  since  1898.  There 
is  some  authority  for  changing  the  meaning  of  words.     I 


know  of  but  one  and  that  has  not  been  cited.  I  am  going 
to  cite  it.  There  is  a  very  interesting  book  called  "Alice 
Through  the  Looking  Glass."  In  a  celebrated  conversation 
between  Humpty-Dumpty  and  Alice,  Humpty-Dumpty 
said,  "  When  I  use  a  word  it  means  precisely  what  I  choose 
it  to  mean,  neither  more  nor  less."  Alice  said,  "But  the 
question  is,  can  you  make  a  word  mean  so  many  different 
things?"  "The  question,"  said  Humpty-Dumpty,  "is  who 
is  to  be  master;  that  is  all."  Upon  ethical  grounds  I  object 
to  the  cost  theory.  I  agree  fully  with  what  the  late  Secretary 
of  State  said, 

"I  do  not  believe  that  railroads  or  other  public  utilities 
are  entitled  to  any  special  consideration.  They  are  entitled 
to  be  treated  just  as  other  people  are  treated." 

In  the  case  of  Smythe  vs.  Ames,  this  was  called  by  him  to 
the  attention  of  the  court: 

"  If  for  instance  railroad  owners  are  demanding  return  upon 
capital  never  actually  invested  in  the  construction  of  the 
road  or  upon  the  original  cost  when  the  property  has  de- 
creased in  value,  they  not  only  have  unfair  advantage  over 
those  who  are  subject  to  competition,  but  may  actually 
profit  by  conditions  which  are  disastrous  to  others." 

Other  people,  when  they  take  their  money  and  invest  it  in 
property,  take  chances  up  or  down,  and  the  difficulty  with 
the  theory  is  that  you  make  the  railroads  take  the  chances. 
There  is  a  railroad  in  western  New  York,  built  in  good  faith, 
by  men  of  high  business  judgment  and  experience,  which 
cost  in  cash  between  four  and  five  million  dollars.  They 
are  entitled  to  a  fair  return  on  the  cost  of  that  road,  and  yet 
that  road  was  sold  the  other  day  for  $300,000.  Under  date 
of  November  1  last,  the  Buffalo  Wrecking  Company  bid  in 
the  track  and  equipment  for  $220,000.  Why  didn't  the 
debtor,  upon  the  debtor  and  creditor  theory,  come  forward 
and  ask  these  men  to  put  up  another  four  or  five  million 
dollars  to  keep  that  road  running?  Somebody  says  roads 
must  be  run  perpetually.  Why  don't  they  run  the  Buffalo 
and  Susquehanna  perpetually?  It  would  not  pay  the  operat- 
ing expenses.  Are  the  owners  obliged  to  put  up  cash  for 
all  eternity  for  that?  I  think  not.  It  is  unfair,  the  invest- 
ment theory  you  talk  about  for  this  reason:  That  if  the 
man  makes  a  good  bargain  and  manages  his  road  cheaply 
by  extraordinary  efforts,  he  gets  no  benefit  from  it,  but  the 
public  gets  the  benefit,  under  the  theory  of  actual  invest- 
ment, while  on  the  other  hand,  although  he  may  use  the 
best  judgment  and  do  the  best  that  he  can,  if  competition  or 
something  else  comes  in  and  the  thing  is  not  a  success,  he  has 
got  to  lose.  Heads  I  win,  tails  you  lose.  The  pubHc  gets 
the  benefit  of  all  your  good  things  and  bears  the  burden 
of  none  of  the  poor  things. 

But  there  is  a  far  deeper  side  to  the  question  than  that. 
When  the  Interstate  Commerce  Commission  comes  to  a 
piece  of  land  that  has  been  bought  by  a  railroad  company 
out  of  earnings,  and  the  railroad  company  is  receiving  a 
dividend,  what  is  the  Interstate  Commerce  Commission 
going  to  do  about  it?  Is  it  going  to  value  it  or  not?  Is  it 
going  to  find  out  the  present  value  as  the  law  says?  If  it 
does  not,  it  is  violating  the  law.     If  it  does,  what  is  it  going 


96 


THE      UTILITIES      MAGAZINE 


to  do  with  it?  Is  it  going  to  allow  anything  for  it  in  rate 
making?  You  say  it  is  inequitable  and  unjust  that  they 
should  have  any  return  upon  it,  because  it  was  not  rightly 
acquired.  The  ethics  of  that  conies  down  to  this:  In  1850, 
p>erhaps  the  railroad  company  exacted  an  unreasonable  rate 
from  A,  B,  C  and  D  and  acquired  that  property  wrongfully. 
In  1915  X,  Y  and  Z  come  in  and  say,  "You  acquired  that 
property  wrongfully."  What  shall  we  do  with  it?  Restore 
it  to  the  people  whose  money  you  took?  No,  give  a  portion 
of  it  to  us  who  did  not  pay  anything  for  it."  Is  that  justice? 
I  say  it  is  not. 

A  man  deeds  a  piece  of  right  of  way  to  the  railroad  com- 
pany to  build  a  road.  To  whom  does  he  give  it?  Does  he 
give  it  to  the  railroad  company  or  to  the  public?  If  he 
wanted  to  deed  it  to  the  public  he  could  do  so.  He  gives 
it  to  the  railroad  company,  gives  the  railroad  the  title  in  fee. 
If  a  man  gives  me  a  watch,  haven't  I  a  right  to  use  it,  to  sell 
it?  Are  you  going  to  come  in  and  say  that  you  should  have 
the  use  of  my  watch?     The  trouble  is,  when  you  open  that 


door  you  are  opening  a  door  that  you  do  not  dream  of. 
There  are  a  very  large  number  of  people  in  this  country 
today  who  believe  that  you  can  go  back  and  inquire  the  way 
a  man  acquired  a  property  and  if  he  did  not  acquire  it 
according  to  their  notion  of  justice  and  equity,  they  would 
take  it  away  from  him  and  take  it  to  themselves.  I  believe 
that  question  is  a  moral  issue  today.  You  come  down 
against  the  common  people,  as  I  have,  and  you  will  find 
that  many  of  them  beUeve  that  Rockefeller  acquired  his 
billion  or  half  billion  dollars  by  improper  methods,  and 
think  it  ought  to  be  taken  away  from  him.  That  is  what 
you  are  proposing  to  do  in  regard  to  land  bought  from 
earnings.  As  a  social  proposition  can  you  stand  for  that? 
Is  it  going  to  be  possible  to  go  back  fifty  years,  one  hundred 
years  and  inquire  how  people  got  title  to  property?  The 
ground  that  we  stand  on  William  Penn  acquired  by  purchase 
from  the  Indians.  How  did  the  Indians  get  the  title  to  the 
land?  They  got  it  with  the  spear  and  arrow,  I  take  it. 
How  are  you  going  to  do  it? 


THE  PROPER  TREATMENT  OF  APPRECIATION  OF  LAND 

By  Milo  R.  Maltbie,  Ph.D. 

Member  Advisory  Board,  Division  of  Valualion,  Interstate  Commerce  Commission;  formerly  Public  Service  Commissioner,  First  District,  New  York 


If  I  understand  Mr.  Stevens  correctly,  if  he  is  right  about 
this  question  of  fair  value,  if  it  means  commercial  value,  and 
if  I  am  running  a  railroad,  and  the  public  authorities — the 
legislatures,  courts  and  commissions — will  keep  their  hands 
off  for  a  minute  or  until  I  fix  rates  and  get  earnings  estab- 
lished for  one  year,  thus  fixing  market  value,  they  can  then  do 
anything  they  please  under  Mr.  Stevens'  theory.  I  will  not 
care,  because  having  established  market  value  by  earnings, 
a  pubUc  body  cannot  interfere  with  market  value  as  it  is 
safeguarded  under  the  Constitution.  They  cannot  touch 
the  rates,  because  they  cannot  touch  earnings. 

I  was  asked  to  speak  on  my  theory  of  the  proper  treatment 
of  appreciation  of  land.  I  shall  assume  for  the  purposes  of 
these  few  comments,  that  the  theory  that  land  is  to  be  valued 
according  to  the  present  value  of  contiguous  property  is 
sound.  Understand,  I  said  I  shall  assume  that;  I  did  not  say 
I  believed  it  just.  It  means,  of  course,  that,  as  the  land 
increases  in  value,  or  rather  as  adjacent  land  increases  in 
value,  the  land  belonging  to  public  utilities  increases  in  value, 
that  it  is  to  be  distinguished  from  other  property  which  de- 
creases in  value  from  year  to  year  and  that  such  land  has  an 
annual  increment  or  an  average  annual  increment  in  value 
from  year  to  year. 

TREATMENT  OF  INCOME  PROPERTY 

I  want  to  call  your  attention  to  one  other  major  premise. 
The  argument  usually  runs  something  like  this: — As  in  fixing 
fair  value  one  takes  the  present  value  of  physical  property 
other  than  land,  so  one  must  take  the  present  value  of  land. 
Hence  as  physical  property  decreases  in  value,  becomes  less 
valuable  as  time  passes,  they  are  treated  equally.     As  Judge 


Hough  says,  it  is  treating  the  plus  and  minus  quantities  alike. 
That  is  the  argument  for  taking  land  at  its  appreciated  value 
when  you  take  other  physical  property  at  its  depreciated 
value. 

What  is  the  next  step  in  the  treatment  of  physical  property? 
It  is  said  that  inasmuch  as  physical  property  other  than  land 
becomes  less  valuable  as  time  passes  and  must  ultimately  be 
replaced  either  by  property  of  the  same  kind  or  of  similar 
kind,  there  must  be  an  allowance  made  in  operating  expenses 
or  added  to  operating  expenses  to  take  care  of  that  deprecia- 
tion from  year  to  year.  I  will  use  a  simple  illustration  and 
eliminate  complications.  If  you  have  a  car  worth  $5,000, 
which  is  to  last  twenty-five  years,  it  decreases  in  value  from 
year  to  year,  and  you  must  ultimately  replace  it.  You  must 
allow  about  $200  (that  is,  $5,000  divided  by  the  time)  in 
expenses  or  added  to  operating  expenses  each  year  in  order 
to  replace  the  car  at  the  end  of  the  time.  I  call  you  atten- 
tion to  the  fact  that  those  who  believe  in  that  theory  do  not 
say  that  you  must  necessarily  spend  $200  a  year  as  you  go 
along,  but  that  you  must  accumulate  a  fund  which  will 
provide  for  the  replacement  of  the  car  when  it  ultimately 
ceases  to  be  used.  The  money  is  not  actually  spent,  but  it  is 
treated  as  an  operating  expense;  it  goes  on  that  side  of  the 
account  just  as  if  it  were  for  coal  or  labor  and  actually  paid 
out.  Such  is  the  treatment  of  depreciation  that  is  supported 
even  by  those  who  do  not  agree  that  in  determining  the  fair 
value  of  the  property  one  should  take  the  depreciated  value 
of  the  property. 

Let  us  pass  from  that  kind  of  projjerty  to  land.  Now  we 
are  on  the  other  side  of  the  ledger,  and  we  have  something 
which  instead  of  decreasing  in  value  increases  in  value  from 


LAND      VALUES 


97 


year  to  year;  that  annual  increment,  if  it  is  to  be  treated 
precisely  as  you  treat  depreciation  on  the  operating  expense 
side  of  the  question,  must  be  treated  as  an  income  or  put  on 
the  income  side  of  the  account. 

IS  APPRECIATION  REAL 

What  are  some  of  the  objections  to  this  theory?  In  the 
first  place,  it  is  objected  that  the  annual  appreciation  is  not 
an  income,  that  one  is  putting  down  a  suppositious  income, 
not  a  real  income.  Is  a  depreciation  allowance  that  is  accu- 
mulated against  some  future  day  an  actual  outlay?  Hence 
to  say  that  appreciation  is  not  a  real  income  is  no  more  of  an 
objection  than  to  say  that  depreciation  is  not  a  real  exp>ense. 
One  is  just  as  real  as  the  other. 

But  let  us  see  whether  or  not  the  appreciation  of  property 
is  not,  after  all,  equal  to  a  real  income.     Suppose  you  have 
land  costing  $100,000,  and  your  rates  are  fixed  on  that  basis 
at  the  time  you  buy  the  land.     In  ten  years  we  will  say  it 
has  increased  to  $200,000  in  value.     If  the  theory  is  correct 
that  the  public  must  allow  a  return  on  the  present  value  of 
the  land,  you  are  entitled  after  ten  years  to  charge  enough 
to  secure  a  fair  return  on  $200,000.     If  you  get  an  income  on 
$200,000  when  you  have  an  investment  of  only  $100,000, 
what  do  you  want  better  than  an  income  of  that  sort?     I  do 
not  know  how  you  feel  about  it,  but  I  would  be  satisfied. 
If  I  could  invest  $100,000  in  a  piece  of  land,  have  an  income  on 
that  $100,000  every  year  and  as  it  increased  in  value  from 
year  to  year  get  an  income  in  addition  on  an  annual  increase 
of  $10,000  (the  first  year  $100,000;  the  second  $110,000,  the 
next  year  $120,000,  and  so  on  up  to  $200,000),  I  would  laugh 
at  anyone  who  said  I  was  not  getting  an  equivalent  to  an 
income  of  $10,000  yearly  on  and  above  my  original  invest- 
ment. 

Suppose  you  went  to  New  York  and  talked  with  families 
that  have  owned  land  on  Manhattan  Island  almost  from  the 
time  the  original  settlers  got  it  from  the  Indians,  and  suppose 
you  said  to  them,  neither  you  nor  your  ancestors  ever  got 
any  income  except  a  return  upon  the  original  cost  upon  the 
basis  of  $24  for  the  Island  of  Manhattan,  they  would  prob- 
ably tap  their  heads  and  say,  "Nobody  at  home";  and  they 
probably  would  add  as  Al  Jolson  says,  "Not  only  is  there 
nobody  at  home,  but  nobody  has  ever  resided  there." 

Some  of  you  probably  have  to  make  out  an  income  tax 
return.    Try   that   theory   on   the   Treasury   Department 


next  spring  and  see  what  the  Treasury  Department  will  say 
about  it.  Say,  "Yes,  my  land  increased  $10,000  in  value 
this  year,  but  it  is  not  income;  it  is  a  fictitious  thing  to  me." 
You  will  find  the  jail  into  which  you  go  is  not  fictitious. 

CAN  APPRECIATION  BE  DETERMINED 

The  second  objection  is  that  increase  in  land  values  is 
not  definite,  it  is  uncertain,  it  is  intangible.  But  what  is 
done  in  the  case  of  depreciation?  An  engineer  comes  along 
and  says  this  property  is  going  to  last  so  long  and  so  much 
should  be  set  aside  for  depreciation.  Probably  that  is  the 
best  that  can  be  done  at  present,  but  it  is  less  certain  than 
appreciation;  because  the  moment  one  says  that  that  certain 
land  is  today  worth  $200,000  and  cost  $100,000  ten  years 
ago,  or  its  value  was  $100,000  ten  years  ago,  you  know  what 
the  appreciation  was  during  that  period. 

The  further  objection  that  I  have  heard  is,  "Well,  that 
must  be  part  of  the  single  tax  theory."  There  are  three 
things  in  this  world  that  you  do  if  you  want  to  eliminate 
your  antagonist.  In  the  first  place,  you  may  say  he  is  a 
Socialist.  That  just  about  disposes  of  him.  He  is  then  be- 
yond the  pale  of  all  reason,  no  matter  what  he  is  saying. 
If  you  cannot  do  that,  you  call  him  "an  impractical  man," 
and  say,  "We  must  deal  with  things  practically."  Of  course, 
that  is  a  knockout  blow.  But  if  he  stUl  survives,  call  him  a 
single  taxer,  and  say  it  with  bated  breath,  for  such  should 
hardly  be  found  in  decent  society. 

But  it  is  not  a  question  of  whether  it  ip  socialism  or  single 
tax.  Is  it  common  sense?  If  you  hold  to  the  theory,  which 
I  believe  to  be  sound,  that  depreciation  must  be  taken  account 
of  in  operating  expenses  or  added  to  operating  expenses, 
you  must  admit  that  appreciation  in  land  values  from  year 
to  year  must  go  down  on  the  income  side  as  an  offset.  Take 
land  and  buildings.  Land  appreciates  and  buildings  de- 
preciate. If  you  do  not  believe  in  the  theory,  you  say  de- 
preciation on  the  buildings  must  be  put  into  operating  ex- 
penses, but  you  will  not  allow  appreciation  on  the  land  to 
be  put  on  the  income  side.  What  does  everybody  do? 
Everyone  figures  that  if  the  land  goes  up  in  value  as  much  as 
the  buildings  go  down,  he  has  just  as  good  a  property  at  the 
end  of  the  year  as  he  had  at  the  beginning.  Why  is  it  not 
logical  to  offset  in  public  utilities  appreciation  of  land  against 
depreciation  of  the  buildings?  If  it  is  logical  as  applied  to 
land  and  buildings,  it  is  logical  as  appKed  to  other  proi)erty. 


OPEN  DISCUSSION 


Mr.  James  C.  Bonbkight,  Graduate  Student,  Columbia 
University: 

It  has  been  a  matter  of  considerable  interest  to  those 
of  us  who  have  been  studying  the  recent  commission  decisions 
to  note  an  apparent  discrepancy  between  certain  opinions 
written  by  Mr.  Stevens  as  Public  Service  Commissioner  of 
New  York,  2d  District,  and  his  more  recent  theories  in 
regard  to  valuation.  It  is,  perhaps,  not  a  reasonable  charge 
to  make  against  him  that  he  has  been  inconsistent,  for  he 


certainly  has  the  right  to  change  his  mind.  However,  in 
view  of  a  recent  statement  by  him  that  this  discrepancy  is 
apparent  rather  than  real,  I  should  like  to  read  some  of 
Mr.  Stevens'  own  remarks  as  chairman  of  the  Commission 
in  the  well-known  case  of  Fuhrmann  vs.  Cataract  Power  & 
Conduit  Co.,  decided  April  2,  1913: — 

"In  a  rate  case,  the  exchange  value  cannot  logically  be  a 
basis  for  inquiry,  for  the  reason  that  the  exchange  value 
depends  on  the  net  income,  present  and  prospective." 


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THE      UTILITIES      MAGAZINE 


"There  would  seem  to  be  no  escape  from  the  conclusion 
that  when  courts  have  used  the  term  'fan*  value'  in  rate 
cases,  they  had  something  in  mind  different  from  'exchange 
value,'  or  in  other  words,  'value.'  It  is  not  to  be  supposed 
that  they  did  not  comprehend  that  value  depends  upon  the 
rate." 

And  again,  after  citing  the  famous  Smyihe  vs.  Ames 
decision,  Mr.  Stevens  says. — 

"This  enumeration  of  matters  to  be  considered  may  be 
regarded  as  a  demonstration  that  the  court  did  not  have  in 
mind  'value'  in  its  economic  sense  of  'exchange  value.'  " 

In  view  of  these  utterances,  I  think  that  it  would  be 
highly  illuminating  if  Mr.  Stevens  would  tell  us  how  he 
reconciles  all  this  with  what  he  has  said  to  night. 

Mr.  Stevens: 

I  undertook  the  examination  of  this  question  a  good  many 
years  ago,  as  early  as  1910.  I  reduced  my  views  to  writing. 
They  were  afterward  published  in  an  opinion  in  the  Second 
District  Commission  of  the  State  of  New  York,  and  I  am 
not  aware  that  I  have  changed  my  views  in  the  slightest 
since  1910.  If  I  have,  I  do  not  know  it.  If  you  will  refer  to 
that  case,  the  West  Chester  Street  Railway  Company,  I  said, 
"An  inquiry  into  the  value  of  railroad  property  as  a  whole 
is  an  investigation  of  the  question  how  much  will  any  person 
or  collection  of  persons  desiring  to  possess  a  property,  how 
much  of  money  or  other  things  will  they  be  willing  to  part 
with  for  the  sake  of  such  possession."  That  was  an  official 
utterance. 

Mr.  Bonbright: 
Was  that  a  rate  case? 

Mr.  Stevens: 
.  No,  sir.  After  pointing  out  that  railroad  property  is  not 
generally  subject  to  purchase  or  sale  as  a  whole,  I  say: 
"In  short,  no  direct  evidence  is  obtainable  concerning  its 
proper  ratio  of  exchange.  The  only  course  open  to  the 
investigator  is  to  select  its  quaUties  or  attributes  which  in 
his  judgment  would  create  a  desire  for  the  property  and  then 
estimate  how  much  that  desire  would  induce  a  prospective 
purchaser  to  surrender  for  his  satisfaction."  I  again  say, 
without  pressing  the  matter  xmduly,  "We  may  say  that  value 
is  nothing  intrinsic  in  things,  but  simply  the  temporary 
measure  of  the  general  average  of  the  desire  for  them  at  the 
moment.  It  is  subjective,  inherent  in  the  mind  which  con- 
ceives it  and  not  in  the  object  in  which  it  is  conceived,  the 
qualities  of  an  object  which  make  it  an  object  of  desir- 
ability to  those  who  have  it  not  and  who  cannot  acquire 
it  without  something  in  exchange  for  it."  That  is  what  I 
understood  by  value.  Again,  I  call  attention  to  the  case  of 
the  Buffalo  and  Susquehanna  Railroad,  which  has  been 
spoken  of  tonight.  I  say:  "The  difference  between  financial 
success  and  financial  failing  lies  in  density  of  traffic.  The 
value  of  an  existing  road  depends  directly  upon  such  density 
of  traffic  and  not  on  the  cost  of  the  road.  If  cost  were  a 
factor  which  determined  the  ratio  of  exchange,  it  is  probable 
there  would  be  but  little  difference  between  the  value  of  the 
two  roads  mile  for  mile." 


In  the  case  the  gentleman  has  very  correctly  cited  I  may 
admit  the  language  is  somewhat,  on  the  face  of  it,  inconsistent 
with  that,  if  you  take  that  by  itself,  but  I  think  if  he  will  read 
the-  whole  opinion  through,  he  will  see  no  inconsistency.  I 
was  troubled  at  the  time  of  writing  the  last  decision  with  the 
apparent  reasoning  in  a  circle  that  Mr.  Maltbie  has  alluded 
to.  I  did  not  at  that  time  see  my  way  clearly  how  to  get 
rid  of  it.  Afterward  I  undertook  an  exhaustive  examination 
of  what  the  Supreme  Court  of  the  United  States  has  said, 
and  the  reason  for  it,  the  occasion  for  it,  and  I  could  see  no 
possible  escape  from  the  proposition  which  I  have  attempted 
to  enunciate  here  tonight;  and  what  I  have  been  arguing 
for  tonight  has  been  for  what  the  law  is  that  we  have  got  to 
observe.  The  law  is  that  if  you  take  the  physical  property  of 
the  railroad  away  from  it  by  condemnation  proceedings, 
you  have  to  pay  the  present  value  of  it.  There  is  no  doubt 
about  that.  Mr.  Eshleman  said  last  night  with  great  cor- 
rectness, that  there  was  absolutely  no  difference  between 
taking  the  property  itself  and  taking  the  use  of  it  away  from 
a  man,  yet  you  have  the  value  in  one  case  meaning  one 
thing  and  in  another  case  meaning  another  thing.  I  am  not 
aware  that  I  have  changed  my  opinions  in  the  expression 
which  the  gentleman  has  read.  Taken  by  itself  it  is  some- 
what inconsistent.  I  know  that;  but  if  you  read  the  whole 
opinion  it  stands  squarely  with  the  other  things  I  have 
said.  I  was  trying  to  get  away  from  that  proposition 
and  the  fact  that  the  market  value,  the  value  depends 
on  the  rate  in  certain  cases. 

Mr.  Harry  Barker,  Editor,  The  Engineering  News: 

Mr.  Maltbie,  I  think,  ought  to  illuminate  us  more  on 
some  phases  of  his  theory,  which  I  seem  to  recognize  as  the 
same  theory  which  was  not  accepted  by  the  highest  courts 
in  the  state  of  New  York  in  some  of  his  cases  as  commis- 
sioner. 

Mr.  Maltbie  apparently  admits  the  increment  of  land  in 
order  to  offset  depreciation;  but  is  it  not  purely  incidental 
that  such  a  result  may  be  secured.  In  general  it  seems  to 
be  regarded  as  equitable  to  deny  an  owner  of  property  an 
imearned  increment  of  value  only  when  he  is  protected 
against  risk  of  a  corresponding  possible  decrement.  Vice 
versa,  perhaps  it  can  be  considered  equitable  to  admit  the 
increment  only  when  there  is  no  protection  against  the 
decrement.  But  each  pair  of  increment-decrement  twins 
then  goes  together — i.e.,  increment  of  land  and  depreciation 
of  operating  plant  cannot  logically  be  paired  off.  If  they 
do  tend  to  offset  is  it  not  accidental? 

Consider  depreciation:  Loss  of  plant  value  is  certain; 
increase  is  doubtful.  A  certain  deterioration  is  inevitable 
since  it  is  the  irreparable  attrition  from  service.  Obsoletion 
and  inadequacy  are  commonly  lumped  in  also  under  deprecia- 
tion and  one  might  expect  that  here  rise  or  fall  of  value  might 
be  problematical.  Yet  even  these  in  the  utility's  experiences 
are  found  to  be  in  one  direction  only — one  has  only  to  think 
of  telephone  equipment,  street-lighting  apparatus,  steam 
engines,  trolley  cars,  gas  retorts,  reciprocating  pumping 
engines,  etc.,  to  see  the  process.  The  company,  under  the 
Knoxville  decisions  of  the  United  States  Supreme  Court,  if 


LAND      VALUES 


99 


diligent,  is  protected  against  loss  of  investment  from  deprecia- 
tion; should  it  therefore  reap  all  the  advantage  of  remotely- 
probable  increased  value  in  plant?  Here,  if  anywhere,  one 
might  expect  that  Mr.  Maltbie's  plan  might  be  applied  so 
that  any  possible  increment  in  some  year  would  enter  the 
earnings  and  decrease  the  compensation  for  depreciation. 

Mr.  Maltbie's  experience  seems  to  have  been  with  land 
that  always  goes  up  in  value.  Some  people  have  land  that 
has  gone  down — in  spite  of  general  nation-wide  increases. 
If  an  elevated  railway  be  built  past  city  business  property 
or  a  railway  cuts  through  a  quiet  residential  section,  then 
contiguous  lands  drop  very  much  in  value.  The  value  of 
utility  land,  which  follows  adjacent  tracts  according  to  the 
Minnesota  rate  cases  of  the  Supreme  Court,  ought  to  go 
down  too.  Whether  the  possible  recovery  and  increment 
are  to  be  admitted  ought  to  depend  on  the  prior  protection 
against  possible  decrements.  If  Mr.  Maltbie's  plan  woidd 
offset  land  decrements  against  land  increments  and  enter 
the  balance  in  expenses  or  income  as  the  case  may  be,  then, 
I  think,  a  more  ready  ear  would  be  lent  by  courts  or  com- 
missions. 

In  any  event  he  would  strengthen  his  case  if  he  emphasized 
his  aim  as  a  preserving  of  the  equities  in  full  measure — ^rather 
than  the  diminution  of  plant-depreciation  allowances  and  the 
reduction  of  rates. 

Dr.  Edward  W.  Bemis,  Member  of  the  Advisory  Board 
to  the  Division  of  Valuation  of  the  Interstate  Commerce  Com- 
mission: 

With  respect  to  Mr.  Stevens'  statement  tonight  that  value 
generally  understood  is  power  in  exchange,  and  that  that  is 
the  view  of  economists  generally,  I  would  agree  most  heartily; 
but  this  brings  up  the  question  whether  the  courts  of  the 
country  have  in  view  that  idea  when  they  speak  of  fair  value. 
Take  the  Consolidated  Gas  Company  of  New  York  or  some 
other  mum'cipal  utility,  whose  rates  have  been  reduced  and 
whose  reduction  has  been  permitted,  by  our  courts.  I  can- 
not conceive  that  the  power  in  exchange  or  the  value  of  those 
companies  was  as  great  immediately  after  the  reduction  of 
rates  as  before.  I  cannot  conceive  that  the  value  or  power  in 
exchange  was  not  reduced  by  the  reduction  of  the  rate.  Not 
in  all  cases  to  be  sure.  There  are  cases  where  there  has  been 
reduction  and  where  the  company  really  does  not  suffer  at 
all  because  of  increase  of  business  and  the  suffering  from  a 
reduction  is  minimized  in  a  great  many  companies  by  a  ten- 
dency in  that  direction.  But  I  think  it  must  be  obvious  to 
students  of  pubUc  utilities  that  there  have  been  many  reduc- 
tions endorsed  by  the  courts  which  obviously  reduce  the  net 
earnings  and  the  value  of  those  utilities,  but  yet  the  fair  value 
has  not  been  affected  in  the  opinion  of  the  court;  that  is,  they 
have  considered  that  it  was  a  legitimate  action  of  the  local 
legislative  power.  It  is  said,  I  am  aware,  that  you  cannot  de- 
termine the  value  of  a  utility,  and  therefore  the  courts  may 
have  dismissed  the  idea  of  value  directly,  because  they  could 
not  determine  it,  and  yet  there  are  utilities  whose  stocks  and 
bonds  are  most  widely  quoted  on  the  stock  exchange.  The 
Consohdated  Gas  of  New  York  is  a  good  illustration.  While 
we  may  criticise  Wall  Street,  I  believe  that  on  the  whole 


the  stock  and  bond  market  in  Wall  Street  is  one  of  the 
most  competitive  markets  in  the  world,  and  that  value  is 
reflected  in  the  case  of  securities  widely  bought  and  sold  like 
Pennsylvania  Railroad,  New  York  Central  or  Consolidated 
Gas  in  New  York.  That  market  does  reflect  pretty  well  the 
power  in  exchange  or  the  value  of  the  entity,  the  corporation, 
whose  stocks  are  then  bought  and  sold.  I  believe  that  it  can 
be  proven  that  these  securities  have  fallen  as  a  result  of  this 
rate  reduction  in  many  cases;  yet  if  I  understood  Mr.  Stevens, 
his  theory  woiJd  lead  us  to  believe  that  such  price  reductions 
would  not  be  allowed  by  the  coiurt,  because  value  with  him 
and  fair  value  are  the  same  thing.  You  can  reduce  the  value, 
I  believe,  and  leave  a  fair  amount  of  property  and  fair  return 
on  that  fair  amount  of  property,  to  use  Mr.  Stevens'  own 
term  in  the  Buffalo  cases.  This  would  be  impossible,  how- 
ever, if  value  be  fair  value.  I  hope  when  the  times  comes  Mr. 
Stevens  will  enhghten  us  as  to  how  he  reconciles  court  de- 
cisions permitting  reductions  in  rates  which  reduce  value 
with  his  claim  tonight  that  value  and  fair  value  are  the  same 
— ^for  if  they  are,  then  rates  cannot  be  reduced  if  the  reduc- 
tion lessens  value  as  is  usually  the  case. 

Mr.  Maltbie: 

May  I  answer  a  question  asked  a  moment  ago  by  Mr. 
Barker?  I  want  to  express  my  thanks  to  him  for  calling 
attention  to  land  which  depreciates  in  value.  When  a  man 
has  a  coal  mine  and  he  says,  "This  mine  is  going  to  run  out  in 
twenty  years, "  what  does  he  do?  He  charges  up  an  annual 
sum  to  provide  for  writing  that  coal  mine  out  of  capital 
account  in  that  time.  That  is  what  ought  to  be  done.  If 
there  is  any  land  that  depreciates  in  value  that  belongs  to 
a  public  utility,  there  ought  to  be  a  provision  made  on  the 
depreciation  side  of  the  accounts  for  the  depreciation  of  the 
land.  I  thought  every  one  would  take  that  for  granted. 
That  is  one  of  the  strongest  arguments  in  favor  of  my  theory, 
for  when  you  have  land  which  appreciates  in  value,  you 
should  put  it  on  the  other  side  of  the  account.  The  gentle- 
man referred  to  a  decision  of  the  highest  court  in  the  State 
of  New  York  refusing  to  accept  this  theory  in  one  of  the 
cases  where  I  wrote  the  opinion.  He  is  entirely  right  about 
it.  The  court  did  refuse  to  accept  it,  but  gave  no  adequate 
reasons  why  it  was  revoked.  If  you  put  depreciation  on 
one  side,  there  must  be  appreciation  on  the  other. 

Mb.  a.  M.  Sakolski,  Secretary,  Valuation  Committee^  The 
Delaware  and  Hudson  Company,  Albany,  N.  Y.: 

How  should  profits  arising  from  appreciation  in  the  value 
of  land  be  determined?  Shall  we  permit  a  man  to  go  to  a 
banker  with  a  balance  sheet  and  say,  "I  have  this  much 
additional  value  in  my  business  because  my  land  has  appre- 
ciated and  therefore  my  business  is  profitable?"  How  are 
we  to  determine  there  is  really  a  profit?  Shall  we  permit  a 
large  corporation  to  publish  an  income  statement  showing 
that  its  land  during  the  year  has  appreciated  half  a  million 
dollars  though  no  actual  cash  profits  were  made?  How  are 
you  going  to  pay  that  out  in  dividends?  The  objection  to 
Mr.  Maltbie's  theory  is  that  it  is  contrary  to  correct  account- 
ing principles;  and  the  determination  of  profits  is  a  matter 


100 


THE      UTILITIES      MAGAZINE 


of  accounting.  It  is  not  a  correct  accounting  principle  to 
\»Tite  up  any  profit  or  income  unless  it  is  realized  in  the  form 
of  cash  or  its  equivalent.  For  that  reason  Mr.  Maltbie's 
theory  will  not  hold  in  business  practice.  Appreciation  is 
undoubtedly  an  asset  but  it  cannot  be  termed  a  profit  unless 
it  enters  the  income  account  as  the  result  of  an  actual  tangible 
transaction.  Increased  value  and  increased  profits  are  not 
identical  conceptions. 

Mb.  John  Bauer,  Assistant  Professor  of  Economics, 
Cornell  University: 

Suppose  that  the  value  has  been  realized  and  put  back 
into  the  land  or  other  form  of  fixed  capital,  when  the  time 
for  dividend  comes  could  you  not  declare  a  dividend  upon  the 
amount? 

Mr.  Maltbie: 

Is  it  expected  that  I  shall  answer  that? 

The  Chairman: 

We  are  getting  away  from  the  subject.    However,  go  ahead. 

Mr.  Maltbie: 

I  refer  the  gentleman  to  the  decision  of  the  Court  of 
Appeals  in  the  case  Mr.  Barker  referred  to,  the  Court  of 
Appeals  of  the  State  of  New  York  in  the  King's  County 
Lighting  Case.  There  you  will  find  that  the  court  makes 
the  point  that  it  is  not  a  question  of  putting  all  of  the  ele- 
ments  on  your  books  that  are  considered  in  rate  cases. 


It  is  a  question  of  the  construction  of  an  account  on  one  side 
representing  expenses  and  putting  a  statement  of  your  in- 
come on  the  other  side.  When  you  construct  your  accounts 
what  should  you  put  in?  You  should  put  in  a  return  upon 
the  value  of  your  property.  When  Mr.  Stevens  comes  along 
and  says  that  in  a  rate  case  we  should  take  not  the  cost  but 
the  present  value,  it  is  not  fair  to  say  that  he  must  recon- 
struct his  books.  He  has  to  do  nothing  of  the  sort.  His 
accounts  ought  to  be  based  on  cost.  But  when  he  claims  a 
return  on  present  value,  it  is  the  appreciated  value  of  the 
land  that  you  put  into  a  temporary  account  in  order  to  de- 
termine the  fair  return.  This  does  not  mean  the  reconstruc- 
tion of  the  books,  and  it  does  not  mean  a  reconstruction  of 
the  income  account,  when  you  take  into  account  appreciation; 
but  it  does  mean  the  construction  of  an  income  account  for 
the  purposes  of  that  case. 

Mr.  Sakolski: 

You  limit  your  theory  to  cases  of  valuation  only? 

Mb.  Maltbie: 

Limit  it  to  rate  cases.  You  also  want  to  know  how  to 
determine  appreciation.  You  have  determined  it  when  you 
fix  the  fair  value  of  the  land.  When  you  say  the  land  cost 
$100,000  and  its  present  value  is  $200,000  and  you  must 
determine  that  according  to  the  theory  that  the  present 
value  of  property  should  be  taken,  you  arrive  at  the 
appreciation,  and  you  can  work  it  out  without  logarithmic 
tables. 


DEPRECIATION    DEFINED^ 

By  Frederic  P.  Stearns 

Consulting  Engineer,  Boston,  Mass. 


The  subject  for  this  morning's  session  is  "Depreciation." 
Probably  there  is  no  other  subject  about  which  there  is  so 
much  controversy,  and  about  which  there  is  such  diversity 
of  opinion.  In  many  cases,  however,  the  diversity  is  not 
so  much  a  difference  of  opinion  as  it  is  a  question  of  mis- 
understanding, owing  to  the  many  senses  in  which  the  word 
is  used  by  different  people.  If  a  person  speaking  on  the 
subject  has  in  mind  one  definition  of  depreciation,  and  a 
person  listening  another,  it  is  obvious  that  the  views  of  the 
speaker  may  not  be  readily  accepted. 

The  primary  definition  of  depreciation  which  is  quite 
generally  accepted  is  "the  lessening  of  value  or  worth," 
and,  as  used  in  connection  with  the  valuation  of  utilities, 
it  is  generally  considered  to  be  the  lessening  of  value  or 
worth  due  to  age  and  use. 

Some  people  hold  the  view  that  as  long  as  a  plant  is  in  good 
operating  condition  and  giving  substantially  as  good  service 
as  a  new  plant  there  is  no  depreciation,  or  at  least  no  accoimt- 

'  Opening  remarks  at  the  Friday  morning  session  of  the  Valuation  Con- 
ference as  presiding  officer. 


able  depreciation.  In  other  words,  they  make  the  character 
of  the  service  the  measiu-e  of  depreciation,  rather  than  the 
loss  of  value  or  wcwrth  of  the  primary  definition. 

Under  recognized  systems  of  accounting  certain  sums  are 
set  aside  as  a  reserve  for  depreciation.  The  amounts  vary 
for  diflferent  kinds  of  property,  and  for  much  short-hved 
property  no  money  is  set  aside,  the  depreciation  being  taken 
care  of  at  the  time  the  property  is  replaced  or  retired  for 
other  reasons.  The  sums  so  set  aside  may  be  more  or  less 
than  the  real  lessening  of  value  or  worth  of  the  property,  and 
yet  they  represent  the  depreciation  as  determined  by  ac- 
counting methods. 

It  is  very  generally  agreed  that  there  should  be  included  in 
the  earnings  of  a  public  service  company  a  sufficient  sum  to 
compensate  for  the  loss  of  value  which  is  taking  place  as 
property  units  grow  older,  but  there  are  many  different 
methods  of  estimating  this  sum  at  different  ages  of  the  unit 
which  give  varying  results.  These  various  methods  may  all 
give  equitable  results  in  the  long  run  if  applied  consistently 
from  the  beginning  to  the  end  of  the  life  of  the  units,  and 


DEPRECIATION 


101 


it  would  be  entirely  equitable  under  such  circumstances  to 
assume  the  depreciation  of  the  unit  to  be  equal  to  the  amount 
received  as  compensation  for  depreciation,  even  though  its 
real  depreciation  is  necessarily  independent  of  the  method 
of  accounting. 

Under  every  method  of  compensating  for  depreciation 
the  aim  is  that  there  shall  be  included  in  the  earnings  the 
whole  value  of  any  property  unit  by  the  time  it  ceases  to 
exist,  omitting  from  consideration  in  this  discussion  cases 
where  the  unit  at  the  end  of  its  life  has  a  scrap  value. 

Some  methods  provide  directly  for  annual  instalments 
which  aggregate  100  per  cent  of 
the  value  of  the  unit  during  its  life, 
but  there  is  one  method  in  very 
general  use,  namely,  the  sinking 
fund  annuity  method,  by  which 
the  sum  of  the  annual  payments 
does  not  aggregate  100  per  cent 
but  a  much  smaller  sum,  and  in 
order  to  provide  the  100  per  cent 
required  by  any  equitable  system, 
it  is  necessary  that  the  annuities 
of  the  sinking  fund  be  invested 
where  they  will  earn  interest,  and 
such  interest  must  be  added  to  the 
annuities  in  order  to  reach  the 
100  per  cent. 

I  am  not  proposing  to  discuss 
the  relative  merits  of  different 
methods  of  providing  for  depre- 
ciation, but  will  make  the  statement  that  any  careful  mathe- 
matical analysis  will  show  that  where  the  sinking  fund  an- 
nuity is  assumed  to  be  the  proper  annual  compensation  for 
the  depreciation  of  the  property  units  of  a  public  utility, 
it  will  be  inequitable  to  deduct  depreciation  from  a  value 
based  on  actual  or  reproduction  cost  in  order  to  obtain  the 
so-called  "fair  value"  upon  which  a  fair  return  shoidd  be 
made. 

In  this  case  the  base  on  which  a  fair  return  should  be 
estimated  must  be  the  value  without  deduction  for  deprecia- 
tion, even  though  it  differs  from  what  may  be  called  the 
"value"  of  the  property.  The  use  of  a  rate  base  which  is 
different  from  the  "  value  "  is  merely  a  means  of  compensating 
for  the  failiu-e  of  the  sinking  fund  annuities  to  add  to  a  total 
of  100  per  cent  during  the  lifetime  of  a  property  unit. 

There  are  many  who,  from  a  consideration  of  the  sinking 
fund  annuity  method  of  providing  for  depreciation,  have 


PART  V 
DEPRECIATION 


DEPRECIATION  DEFINED 

KINDS  OF  DEPRECIATION 

HOW  DEPRECIATION  IS  DETERMINED 

METHODS  OF  PROVIDING  FOR  DEPRECIA- 
TION 

KINDS  OF  DEPRECIATION  FUNDS 

RELATION   OF  DEPRECIATION  TO  FAIR 
VALUE 

RELATION  OF  DEPRECUTION  TO  RATE  OF 
RETURN 


proved  to  their  own  satisfaction  and  could  prove  to  others 
that  it  is  inequitable  in  such  cases  to  deduct  depreciation  in 
obtaining  a  rate  base,  but  they  sometimes  apply  the  same 
reasoning  to  other  methods  of  compensating  for  depreciation 
where  it  is  equitable  to  make  deductions  for  depreciation. 
The  failure  to  recognize  that  the  method  of  determining 
compensation  for  depreciation  affects  the  question  of  whether 
or  not  depreciation  should  be  deducted  from  cost  new  has 
been  a  cause  of  much  misunderstanding. 

Practically  all  public  utilities  are  continuing  properties 
which  never  reach  the  end  of  their  life,  and  it  is  possible  to 

adopt  a  sufficiently  liberal  policy 
of  appropriating  money  from  earn- 
ings for  making  replacements  and 
improvements  of  the  property  to 
prevent  loss  of  value  in  the  prop- 
erty as  a  whole.  Many  people, 
having  in  view  the  property  as 
a  whole  and  knowing  that  it  is 
maintained  in  excellent  condition 
by  liberal  expenditures  from  earn- 
ings, properly  believe  that  the 
value  of  the  property  as  a  whole 
has  not  depreciated  below  that  rep- 
resented by  the  invested  capital. 

Although  the  value  of  the  whole 
property  may  be  kept  intact  in  this 
way,  most  units  of  property  depre- 
ciate, as  stated  in  the  Knoxville  de- 
cision, "from  the  moment  of  their 
first  use,"  and  become  less  and  less  valuable  until  they  finally 
go  out  of  service  and  have  no  more  than  a  second-hand  or 
scrap  value. 

The  depreciation  of  the  unit  is  one  that  can  be  estimated 
with  a  moderate  degree  of  accuracy,  as  the  errors  which 
occur  in  dealing  with  different  units  will  to  a  large  extent 
offset  one  another.  Any  attempt  to  tell  how  much  money 
shall  be  spent  from  earnings  to  keep  the  investment  in  the 
whole  property  intact  is  likely  to  be  wide  of  the  mark. 
Without  regard  to  the  relative  merits  of  these  two  conceptions 
of  depreciation,  it  will  readily  be  seen  that  they  are  a  fruitful 
source  of  misunderstanding. 

I  presume  the  time  will  come  when  there  will  be  a  clearer 
understanding  and  a  more  nearly  uniform  practice  in  regard 
to  depreciation  than  at  present,  and  that  the  word  "depre- 
ciation" will  not  be  used  in  as  many  different  senses  as  at 
present.  These  results  will  be  achieved  by  discussions  such 
as  are  being  presented  here. 


102 


THE      UTILITIES      MAGAZINE 


COURT  DECISIONS  ON  DEPRECIATION 

By  Jacob  H.  Goetz 

0/  Counsel,  Public  Service  Commission  First  District,  New  York 


DIVERSITY    OF   OPINION 

DESPITE  the  attention  which  has  been  increas- 
ingly devoted  to  this  problem  in  recent  years, 
there  still  exists  a  contrariety  of  opinion  con- 
cerning it,  and  from  the  state  of  diflBculty  and  uncer- 
tainty we  naturally  turn  to  the  courts  for  the  finality 
to  be  expected  in  the  authoritativeness  of  legal  inter- 
pretation. 

However,  the  quantity  of  legal  literature  extant  on 
the  subject  is  not  fairly  proportionate  to  the  mass  of 
judicial  diffusion  among  the  8,700  volumes  of  American 
court  decisions,  the  ignorance  of  which,  we  are  warned, 
excuses  no  one.  While  the  decisions  already  promul- 
gated have  helped  in  delimiting  the  excursions  of  legis- 
lators, regulators  and  judges  in  this  field,  nevertheless 
they  have  also  contributed  in  no  small  degree  to  the 
contention  and  confusion  which  usually  characterize 
a  fresh  attempt  to  deal  with  the  question.  An  analysis 
and  comparison  of  the  court  decisions  on  depreciation 
hardly  disclose  that  passion  for  uniformity  which  a 
distinguished  publicist  recently  declared, 

"pervades  all  human  nature,  and  has  been  one  of  the  pro- 
foundest  causes  of  the  struggles  which  constitute  so  great  a 
part  of  the  story  of  the  life  of  man  on  earth. "' 

This  may  seem  remarkable  in  view  of  the  fact  that 
valuation  questions  may  come  before  the  United  States 
Supreme  Court  upon  a  review  of  constitutional  issues, 
and,  as  decisions  of  that  court  are  binding  upon  all,^ 
uniformity  ought  to  follow. 

The  reason  for  this  diversity  among  the  judges  is  not 
difficult  to  trace.  It  is  a  phase  of  modern  treatment 
and  growth.  Even  after  it  had  become  the  practice  of 
mercantile  establishments  to  charge  off  a  large  per- 
centage of  their  annual  earnings  to  a  depreciation  fund, 
public  service  corporations  were  slow  to  recognize  this 
necessity.  The  fact  that  a  future  depreciation  account 
was  a  novelty  in  the  accounting  of  these  corporations 
is  acknowledged  as  the  reason  why  so  scant  attention 
was  given  by  the  courts  to  this  subject  in  litigation.' 

In  earlier  rate  cases,  counsel  for  the  litigants  did  not 
perceive  the  far-reaching  effects  of  the  subject,  and  it 
was  not  sufl5ciently  dwelt  upon  by  the  Federal  and 

'  John  Bassett  Moore,  "The  Passion  for  Uniformity,"  62  Pa.  Law  Rev., 
May,  1914.  For  illustration  of  the  conflicting  views,  see  People  ex.  rel. 
Bklyn.  Hts.  R.R.  Co.  vs.  Tax  Cdmmrs.  (1910),  69  Misc.  646,  656,  659;  San 
Diego  Water  Co.,  vs.  San  Diego  (1897),  118  Cal.  556. 

'  Pub.  Serv.  Gas.  Co.  vs.  Board  of  Public  Vtility  Corporations  (1903),  87 
Atlantic,  651,  657. 

» People  ex  rel.  Brooklyn  Hts.  R.  R,  Co.  vs.  Tax  Commissioners  (1910),  69 
N.  Y.  Misc.,  646,  657. 


other  courts  because  the  question  was  involved  in  suits 
in  equity  to  restrain  the  enforcement  of  rates  fixed  by 
ordinance  or  statute  which  presented  to  the  court  the 
sole  question  whether  the  effect  of  such  ordinance  or 
statute  was  confiscatory  and,  hence,  in  violation  of  the 
statute,  and  the  court,  having  determined  for  or  against 
the  constitutionality  of  the  ordinance  or  statute  under 
consideration,  paid  scant  attention  to  matters  of  detail 
not  necessarily  involved  in  the  precise  question  before 
it.* 

Definite  ideas  concerning  the  subject  were  not  re- 
flected in  the  early  decisions.  Even  cases  which 
mentioned  reproduction-cost  less  depreciation  contained 
no  discussion  of  the  factor.  A  few  cases  which  in- 
directly discussed  the  subject  in  its  relation  to  the 
ascertainment  of  net  earnings  failed  to  disclose  a  lucid 
conception  of  what  was  meant  by  depreciation  in  any 
aspect.  It  was  the  increasing  recurrence  of  regulatory 
exertions,  especially  in  rate  matters,  that  gave  the 
effective  impulse  to  the  development  of  the  depreciation 
factor  into  so  broad  and  vital  a  question. 

The  differences  in  the  theory  and  practice  which 
arose  even  after  the  subject  had  received  extensive 
consideration  are  due  largely  to  the  failure  to  distinguish 
between  the  classes  of  depreciation  and  the  purposes 
to  which  depreciation  may  be  applied.  Text  writers 
and  courts  have  constantly  quoted  excerpts  from  cases 
involving  the  subject  without  regard  to  whether  the 
particular  case  affected  a  valuation  for  a  basis  of  rate- 
making,  a  calculation  of  earnings  attributable  to  the 
return  under  a  specific  rate,  a  condemnation  or  pur- 
chase, a  tax  levy, '  an  accounting  or  a  capitalization. 
That  there  are  underlying  differences  is  obvious.  It 
may  well  be  that,  if  the  relation  of  the  problem  to  the 
several  divisions  were  discussed  and  the  questions  were 
solved  separately,  and  the  true  principles  affecting  each 
division  were  ascertained,  without  applying  to  one  state 
of  facts  and  theory  precedents  which  have  been  applied 
to  a  dissimilar  state  of  facts  and  theory,  the  views  and 
expressions  upon  the  subject  could  be  co-ordinated  and 
ultimately  harmonized. 

DEFINITION  OF  DEPRECIATION 

The  courts  have  invariably  avoided  all-inclusive 
definitions  of  legal  terms,  but  there  have  been  several 
definitive  statements  by  the  courts  which  should  be 
referred  to  for  a  better  understanding  of  this  discussion. 

*  People  ex  rel.  Kings  Co.  Ltg.  Co.  vs.  Public  Seniee  Commission  (1913), 
156.  N.  Y.  App.  Div.  603.  614-615. 


DEPRECIATION 


103 


In  the  rate  case  of  Cumberland  Tel.  &  Tel.  Co.  vs.  City 
of  Cumberland,^  the  court  accepted  as  "sufficiently 
accurate"  the  following  definition  furnished  by  one 
of  the  witnesses  of  a  form  of  depreciation: 

"Depreciation  may  be  defined  as  the  loss  in  value  of  some 
destructible  property  over  and  iabove  current  repairs." 

It  has  also  been  described  as  the  "constant  deteriora- 
tion of  the  plant  which  is  not  made  good  by  ordinary 
repairs  which,  of  course,  operates  continually  to  lessen 
the  value  of  the  tangible  property  which  it  affects."^ 
Other  cases  define  the  measure  of  depreciation  in  de- 
scribing it  as  due  to  age  and  use,'  to  wear  and  tear,  ' 
improvements  in  the  art,  municipal  improvements,* 
and  to  inadequacy  and  obsolescence.^  Depreciation 
is  divided  into  two  classes  or  species:  Physical,— due  to 
ordinary  wear  and  tear,  and  functipiialj  due  to  neces- 
sary replacement  of  equipment  before  it  is  worn  out.* 
Depreciation  is  further  divided  into  complete  and  in- 
complete depreciation.  Complete  depreciation  repre- 
sents that  part  of  the  original  plant  which  through 
destruction  or  obsolescence  has  actually  perished  as 
useful  property;  incomplete  depreciation  represents 
the  impairment  in  value  of  the  parts  of  the  plant  which 
remain  in  existence  and  are  continued  in  use.' 

As  Mr.  Justice  Hughes  pointed  out  in  the  Minnesota 
Rate  Cases,' 

"  It  is  not  a  matter  of  formulas,  but  there  must  be  a  reas- 
onable judgment  having  its  basis  in  a  proper  consideration 
of  all  relevant  facts." 

DEPRECIATION  AS  A  FACTOR  IN  PHYSICAL 
VALUATIONS  FOR  BASIS  OF  RATE  RETURN 

The  phase  of  depreciation  about  which  there  exist 
the  greatest  contention  and  difference  of  opinion  is 
that  affecting  valuation  as  a  basis  of  return. 

No  inflexible  rule  has  been  laid  down  by  the  legis- 
latures or  courts  for  the  ascertainment  of  fair  value  for 
rate  making  purposes,  but  the  reproduction-cost-less- 
depreciation  method  is  the  most  frequently  used.* 
The  adoption  of  this  method  resulted  from  the  inquiry 
which  the  courts  made,  in  cases  attacking  the  validity 
of  rates  as  invading  property  rights,  as  to  the  amount 

>  (1911),  187  Fed.  637,  653. 

'  Peo.  ex  rel.  Jamaica  Water  Supply  Co.  vs.  Tax  Commrs.  (1909),  196  N.  Y. 
89, 57. 

» City  of  KnoxviUe  vs.  KnoxmUe  Water  Co.  (1909),  212  U.  S.  1,  9. 

*  Cumberland  Tel.  &  Tel.  Co.  vs.  City  of  LouisvUle  (1911),  187  Fed.  637,  654. 

»  Pioneer  Tel.  &  Tel.  Co.  vs.  Wesienhaver  (1911),  29  Okla.  429, 454. 

'  People  ex  rel.  Brooklyn  Hts.  R.  R.  Co.  vs.  Tax  Commissioners  (1910),  69 
Misc.  646,  655;  People  ex  rel.  Queens  Co.  Water  Co.  vs.  Woodbury  (1910),  67 
Misc.  490,  493,  affd.  142  N.  Y.  App.  Div.  943,  944,  143  N.  Y.  App.  Div. 
618,  and  202  N.  Y.  619. 

'  KnoxviUe  vs.  KnoxviUe  Water  Co.  (1909),  212  U.  S.  1, 13. 

» (1912),  230  U.  S.  352,  434. 

»  Pioneer  T.  &  T.  Co.  vs.  Westenhaver  (1911),  29  Okla.  429.  433-434. 


of  property  involved,  for  rights  in  property  which  did 
not  exist  could  not  be  impaired. 

The  celebrated  case  of  Smythe  vs.  Ames^"  may  be  said 
to  have  laid  the  basis  of  the  depreciation  factor  in  as- 
certaining reproduction  value  and  in  calculating  operat- 
ing charges  to  ascertain  the  amount  of  return. 

The  constitutional  guarantees  affecting  rates  extend 
to  all  elements  of  valuation." 

The  rate  cases  in  which  the  factor  of  depreciation 
in  a  physical  valuation  was  first  considered  were  two 
cases  in  the  Federal  Court  which  involved  a  species  of 
depreciation  nearly  akin  to  obsolescence. 

Up  to  the  time  of  the  KnoxviUe  decision  in  1909, 
there  were  but  few  other  court  cases  in  which  the  rela- 
tion of  depreciation  to  physical  valuation  was  discussed.^^ 
The  City  of  KnoxviUe  appealed  from  a  decree  of  the 
United  States  Circuit  Court  permanently  enjoining 
the  enforcement  of  a  city  ordinance  fixing  maximum 
rates  to  be  charged  by  the  water  company  upon  the 
ground  of  constitutional  invalidity.  No  deduction 
was  found  to  have  been  made  for  depreciation.  The 
court,  speaking  by  Moody,  J.,  said:'' 

"The  first  fact  essential  to  the  conclusion  of  the  Court  be- 
low is  the  valuation  of  the  property  devoted  to  the  public 
uses,  upon  which  the  company  is  entitled  to  earn  a  return. 
.  .  .  .  The  valuation  was  determined  by  the  master 
by  ascertaining  what  it  would  cost,  at  the  date  of  the  ordi- 
nance, to  reproduce  the  existing  plant  as  a  new  plant.  The 
cost  of  reproduction  is  one  way  of  ascertaining  the  present 
value  of  a  plant  like  that  of  a  water  company,  but  the  test 
would  lead  to  obviously  incorrect  results,  if  the  cost  of  re- 
production is  not  diminished  by  the  depreciation  which  has 
come  from  age  and  use 

"The  cost  of  reproduction  is  not  always  a  fair  measure  of 
the  present  value  of  a  plant  which  has  been  in  use  for  many 
years.  The  items  composing  the  plant  depreciate  in  value 
from  year  to  year  in  a  varying  degree 

"  It  is  not  easy  to  fix  at  any  given  time  the  amount  of  de- 
preciation of  a  plant  whose  component  parts  are  of  different 
ages  with  different  expectations  of  life.  But  it  is  clear  that 
some  substantial  allowance  for  depreciation  ought  to  have 
been  made  in  this  case.     The  officers  of  the  company,  alio 

i»  (1896),  169  U.  S.  466,  546-547. 

"  Bonbright  vs.  Corpn.  Commrs.  of  Arizona  (1913),  210  Fed.  44,  48. 

^'Capital  City  Gas  Light  Co.  vs.  Des  Moines  (1896),  72  Fed.  Rep. 
829,  843;  Milwaukee  El.  Ry.  &  Lt.  Co.  vs.  City  of  Milwaukee  (1898),  87 
Fed.  577;  San  Joaquin  &  K.  R.  C.  &  I.  Co.  vs.  Stanislaus  Co.  (1902), 
113  Fed.  930;  reversed  in  Stanislaus  Co.  vs.  San  Joaquin  &  K.  R.  C.  &  I. 
Co.  (1904),  192  U.  S.  201;  Columbus  Railway  &  Light  Co.  vs.  City  of 
Columbus,  decided  in  1906,  No.  1206  in  Eq.,  U.  S.  Circuit  Ct.,  So.  Dist.  of 
Ohio,  Rept.  of  Spl.  Master  T.  P.  Linn,  confirmed  by  the  Circuit  Court 
without  opinion;  Consolidated  Gas  Co.  vs.  City  of  N.  Y.  (1907),  U.  S.  C. 
C,  So.  Dist.  N.  Y.  Rept.  of  Arthur  A.  Masten,  Master;  affd.  (1907),  157 
Fed.  849;  revd.  Willcox  vs.  Consolidated  Gas  Co.  (1909),  212  U.  S.  19;  San 
Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanislaus  (1908),  163  Fed.  567,  572 
(1911),  191  Fed.  875,  revd.  (1914),  233  U.  S.  454. 

"  City  of  KnoxmUe  vs.  KnoxviUe  Water  Co.  (1909),  212  U.  S.  1,  pp.  9, 
10, 13. 


104 


THE      UTILITIES      MAGAZINE 


intuitu,  estimated  what  they  called  '  incomplete  depreciation' 
of  this  plant,  which  we  understand  to  be  the  depreciation 

of  the  surviving  parts  of  it  still  in  use,  at  $77,000 

It  is  enough  to  say  that  there  should  have  been  a  consider- 
able diminution,  sufficient  to  raise  the  net  income  found  by 
the  court  above  6  per  cent,  upon  the  whole  valuation  thus 
diminished. " 

After  discussing  various  other  phases  of  the  case, 
and  considering  depreciation  in  another  sense,  i.  e.,  in 
its  relation  to  earnings,  the  court  continues: 

"The  company's  original  case  was  based  upon  an  elaborate 
analysis  of  the  cost  of  construction.  To  arrive  at  the 
present  value  of  the  plant  large  deductions  were  made  on 
account  of  the  depreciation.  This  depreciation  was  divided 
into  complete  depreciation  and  incomplete  depreciation. 
The  complete  depreciation  represented  that  part  of  the 
original  plant  which  through  destruction  or  obsolescence  had 
actually  perished  as  useful  property.  The  incomplete  de- 
preciation represented  the  impairment  in  value  of  the  parts 
of  the  plant  which  remained  in  existence  and  were  continued 
in  use.  It  was  urgently  contended  that  in  fixing  upon  the 
value  of  the  plant  upon  which  the  company  was  entitled  to 
earn  a  reasonable  return  the  amounts  of  complete  and  in- 
complete depreciation  should  be  added  to  the  present  value 
of  the  surviving  parts.  The  court  refused  to  approve  this 
method,  and  we  think  properly  refused.  A  water  plant, 
with  all  its  additions,  begins  to  depreciate  in  v^alue  from  the 
moment  of  its  use." 

The  court  in  the  following  parts  of  the  opinion  in 
fact  discussed  depreciation  in  both  its  relation  to  valu- 
ation and  its  relation  to  earnings,  as  if  the  problem  was 
governed  by  the  same  rules.  The  court  held  that  the 
cost  of  reproduction  should  be  diminished  "by  the 
depreciation  which  has  come  from  age  and  use."  This 
might  be  contended  to  mean  only  actual  or  complete 
depreciation.  But  the  subsequent  ruling  that  complete 
and  incomplete  depreciation  should  not  be  added  to 
the  present  value  of  the  surviving  parts  justifies  the  as- 
sumption that  the  court  included  in  the  term  deprecia- 
tion what  is  usually  described  as  "accrued  depreciation  " 
or  "theoretical  depreciation."  It  seems,  however,  that 
the  court  did  not  include  accrued  functional  deprecia- 
tion as  distinguished  from  accrued  physical  depreciation. 

It  should  be  kept  in  mind  that  this  part  of  the  dis- 
cussion relates  only  to  depreciation  as  a  factor  in  the 
physical  valuation. 

Following  the  authority  of  the  BJioxville  Water 
Case,  the  courts,  in  later  cases,  gave  full  recognition 
to  the  deduction  of  depreciation  from  cost  to  reproduce 
in  order  to  find  a  basis  for  testing  the  reasonableness  of 
rates. ^    The  principal  cases  upon  the  question  of  de- 

i  E.  g.,  Lincoln  Gas  &  Elec.  Lt.  Co.  vs.  City  of  Lincoln  (1909),  182  Fed.  926; 
La.  R.  R.  Coram,  vs.  Cumberland  Tel.  &  Tel.  Co.  (1909),  212  U.  S.  414;  Home 
Tel.  Co.  vs.  City  of  Carthage  (1911),  235  Mo.  644;  Cumberland  Tel.  &  Tel.  Co. 
vs.  CUy  of  Louisville  (1911),  187  Fed.  C37;  Pioneer  Tel  &  Tel.  Co.  vs.  Westen- 


preciation  are,  perhaps.  Pioneer  Telephone  &  Telegraph 
Co.  vs.  Westenhaver,^  The  Minnesota  Raue  Cases,^  and 
The  People  ex  ret.  Kings  County  Lighting  Co.  vs.  Public 
Service    Commission.* 

In  the  Pioneer  Telephone  &  Telegraph  Case,  the 
Oklahoma  Supreme  Court  does  not,  however,  specify 
the  measure  of  the  depreciation  to  be  deducted. 

In  the  Minnesota  Rate  Cases,  the  lower  court 
practically  rejected  the  depreciation  factor  as  applicable 
to  valuation.  The  Supreme  Court,  speaking  by  Hughes, 
J.,  holds  this  ruling  to  have  been  erroneous,  but  rules 
.  that  the  depreciation  which  should  be  deducted  is 
"the  actual  existing  depreciation,"  and  cites,  as  an 
example,  "old  structures  and  equipment  remaining  on 
hand." 

The  Elnoxville  Water  Case,  although  emanating 
from  the  highest  judicial  authority,  did  not  terminate 
the  struggle  about  this  question.  The  contest  against 
the  depreciation  rule  was  waged  more  forcibly  in  a 
case  before  the  New  York  Public  Service  Commission 
than  in  any  other  case.  The  Appellate  Division  of  the 
Supreme  Court,  held  however:' 

(1)  That  it  seems  to  be  thoroughly  established  that 
the  value  of  the  tangible  property  upon  which  the 
company  was  entitled  to  a  rate  which  will  procure  a 
fair  and  just  return  is  the  present  value — that  is,  at 
the  time  of  the  appraisement  for  rate  making  purposes. 

(2)  That,  in  the  absence  of  accurate  evidence  as  to 
actual  value,  the  cost  of  reproduction,  new,  takes  the 
place  thereof. 

(3)  That,  as  the  property  valued  is  not  new,  in  order 
that  "cost  of  reproduction  new,"  may  represent  the 
actual  condition — the  amount  presently  invested — 
there  must  be  a  deduction  therefrom. 

(4)  "That  this  represents  the  amount  required  to 
replace  apparatus  still  in  use,  but  in  process  of  wearing 
out,  at  the  end  of  useful  service. " 

(5)  That  this  allowance  for  depreciation  has  been 
made  in  various  kinds  of  cases  where  the  present  value 
is  required  to  be  estimated,  that  is,  in  condemnation 

haver  (1911),  29  Okla.  429;  San  Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanislaus, 
163  Fed.  567;  Spring  Valley  Waterworks  vs.  City  &  Co.  of  San  Francisco  (1911), 
192  Fed.  137;  Des  Moines  Water  Co.  vs.  City  of  Des  Moines  (1911),  192  Fed. 
193;  Montana,  Wyoming  &  So.  R.  R.  Co.  vs.  Bd.  of  R.  R.  Commrs.  of  Mont. 
(1912),  198  Fed.  991;  The  Minnesote  Rate  Cases  (1912),  230  U.  S.  352;  Wyo- 
ming &  So.  R.  R.  Co.  vs.  Bd.  ofR.  R.  Commrs.  of  Mont.  (1912),  198  Fed.  191; 
Bonbright  vs.  Corpn.  Commrs.  of  Arizona  (1913),  210  Fed.  44;  People  ex  rel. 
Kings  Co.  Ltg.  Co.  vs.  Pub.  Serv.  Commn.  of  N.  Y.  (1913),  156  N.  Y.  App. 
Div.  603  (1914),  216  N.  Y.  479;  Public  Serv.  Gas  Co.  vs.  Bd.  of  Public  Utils. 
Commrs.  of  N.  J.  (1913),  87  Atl.  651;  Murray  vs.  Public  Utils.  Commn.  of 
Idaho  (1915),  150  Pac.  47. 

=  (1911),  29  Okla.  429,  441. 

'  (1912),  230  U.  S.  352,  457-458. 

*  (1913),  156  N.  Y.  App.  Div.  603;  (1914),  210  N.  Y.  479. 

'  People  ex  rel.  Kings  County  Ltg.  Co.  vs.  Public  Service  Commn.  (1913),  156 
N.  Y.  App.  Div.  603,  610-612;  s.c.  (1914),  210  N.  Y.  479, 495. 


DEPRECIATION 


105 


or  contract  cases,  in  special  franchise  tax  cases,  and  in 
rate  cases. 

The  decision  upon  the  issue  of  depreciation  was  made 
by  the  Appellate  Division  of  the  Supreme  Court  and 
not  by  the  Court  of  Appeals,  which  is  the  highest  court 
in  the  state.  The  Appellate  Division,  while  wholly 
rejecting  the  contention  that  accrued  depreciation 
should  not  be  deducted  from  the  cost  to  reproduce  new, 
does  not  commit  itself  as  to  the  measure  of  depreciation 
to  govern  cases  of  this  kind,  that  is,  whether  functional 
as  well  as  physical  causes  should  be  included,  although 
the  Commission  itself  did  use  depreciation  in  its  largest 
measure. 

A  case  expressly  recognizing  the  inclusion  of  func- 
tional depreciation  is  that  of  Des  Moines  Water  Co.  vs. 
City  of  Des  Moines,  decided  by  the  Federal  District 
Court  in  1911. ' 

The  latest  "  disturbing  factor"  upon  the  subject  is 
the  decision  in  Murray  vs.  Public  Utilities  Commission 
of  Idaho,^  decided  by  the  Supreme  Court  of  Idaho  on 
July  1,  1915.  It  has  caused  widespread  comment, 
because  it  explicitly  holds  that  only  actual  tangible 
depreciation,  and  not  theoretical  or  accrued  deprecia- 
tion should  be  deducted. 

There  were  a  few  other  cases  since  the  Knoxville 
case  which  referred  to  the  question  of  depreciation 
deduction,  but,  while  following  the  ruling  in  the  Knox- 
ville Case  that  depreciation  should  be  deducted,  they 
fail  to  disclose  a  commitment  as  to  whether  the  deduc- 
tion should  cover  accrued  depreciation  as  well  as  actual, 
and  also  functional  depreciation  as  well  as  physical.' 

There  are  a  few  other  questions  corollary  to  the 
main  question.  Having  determined  the  measure  of 
depreciation  to  be  applied,  the  amount  to  be  deducted 
is  purely  an  engineering  question,  and  a  recital  of  the 
percentages  would  not  be  helpful  as  indicating  principles 
laid  down  by  the  courts.'' 

It  has  frequently  been  contended  by  the  public 
utilities  in  support  of  their  objection  to  the  deduction 

>  (1911),  192  Fed.  193,  197. 

2  (1915),  150  Pac.  R.  47,  50. 

»  Lincoln  Gas  &  Elec.  Lt.  Co.  vs.  City  of  Lincoln  (1909),  182  Fed.  926,  928; 
reversed  in  s.c.  (1912),  223  U.  S.  365;  Contra  Costa  Water  Co.  vs.  Oakland 
(1911),  159  Cal.  323,  341-342;  Home  Td.  &  Tel.  Co.  vs.  City  of  Carthage  (1911), 
235  Mo.  644,  664;  Spring  Valley  Waterworks  Co.  vs.  City  &  Co.  of  San  Fran- 
cisco (1911),  192  Fed.  137,  145;  San  Joaquin  &  Kings  R.  C.  &  1.  Co.  vs. 
Stanislaus  Co.  (1911),  191  Fed.  875,  881,  revisers  (1914),  233  U.  S.  454; 
Montana,  Wyoming  &  Southern  R.  R.  Co.  vs.  Bd.  of  R.  R.  Commrs.  of  Mon- 
tana (1912),  198  Fed.  991,  1004, 1005;  Bonbrighi  vs.  Corpn.  Commn.  of  Arizona 
(1913),  210  Fed.  44,  51;  P.  S.  Gas  Co.  vs.  Bd.  of  Pub.  Util.  Commrs.  (1913), 
87  Atl.  R.  651,  657. 

*  See  \Miitten,  Valuation  of  P.  S.  Corpns.,  I.  401,  II,  1182;  Floy,  Valuation 
of  Public  Utility  Properties,  p.  168;  Foster,  Engineering  Valuation  of  Public 
Utilities  and  Factories,  165;  Wyer,  Regulation,  Valuation  and  Depreciation  of 
Public  Utilities,  p.  101;  Cumberland  I.  &  1.  Co.  vs.  City  of  Louisville  (1911), 
187  Fed.  637;  San  Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanislaus  (1898),  163 
Fed.  567;  (1911),  191  Fed.  875,  881;  reviser  (1914),  233  U.  S.  454; 
Bonbright  vs.  Corpn.  Comm,  of  Arizona  (1908),  210  Fed.  44,  51. 


of  depreciation  from  value  that,  as  the  depreciation 
reserve  representing  the  accrued  depreciation  of  the 
property  was  not  earning  a  fair  return  upon  the  accu- 
mulation, the  investors  were  deprived  of  a  return  upon 
the  amount  of  their  investment  which  is  depreciated, 
but  for  which  provision  was  made  through  the  depre- 
ciation reserve.  The  point  seems  to  have  been  ignored 
in  the  cases,  except  in  the  Bonbright  case,  which  holds 
that  depreciation  reserve  is  to  be  added  to  the  value 
of  the  property.^ 

Brief  mention  may  be  made  of  the  method  of  de- 
preciation employed.  The  straight  line,  sinking  fund 
and  present  worth  methods  are  the  principal  ones.  In 
rate  valuations,  the  courts  have  generally  approved 
the  sinking  fund  method.' 

To  summarize,  it  may  be  stated  that  the  court  de- 
cisions upon  the  subject  have  definitely  held  that,  to 
test  the  value  of  a  plant  by  cost  of  reproduction,  de- 
preciation must  be  deducted  for  wear  and  tear;  that 
the  Knoxville  Case  and  the  Kings  County  Lighting 
Case  included  in  the  depreciation  both  complete  and 
incomplete  depreciation,  whereas  the  Minnesota  Case 
referred  only  to  actual  depreciation,  and  the  Idaho 
case  permitted  a  deduction  only  for  actual  depreciation, 
and  that  the  Des  Moines  Case  included  in  the  deduction 
also  functional  depreciation,  as  did  impliedly  the  Kings 
County  Lighting  Case.  It  may  fairly  be  said  that  there 
is  no  leading  case  expressly  holding  that  functional 
depreciation  should  be  included  in  addition  to  physical 
depreciation. 

DEPRECIATION    AS    A    FACTOR    IN    ASCER- 
TAINING NET  INCOME  REPRESENTING 
RETURN  UNDER  A  RATE 

In  rate  cases,  two  elements  must  be  determined: 
(1)  the  value  of  the  property  upon  which  the  utility  is 
entitled  to  a  return;  (2)  the  rate  of  return  upon  the 
value.  ^ 

Although  the  public  utilities  have  contended  against 
a  deduction  from  valuation  for  depreciation,  while 
consumers  and  officials  have  contended  for  it,  the  con- 
tentions are  reversed  with  reference  to  the  deduction 
from  earnings  for  depreciation.  The  courts  have  by 
no  means  been  in  accord  upon  the  answer  to  the  ques- 
tion whether  the  periodic  depreciation  allowance 
should  be  made  at  the  expense  of  the  consumers,  al- 
though, if  the  KJaoxville  Water  Case  be  accepted  as  the 
final  authority,  the  question  is  now  settled.     Nor  have 

'  Bonbright  vs.  Corpn.  Commn.  of  Ariz.  (1908),  210  Fed.  44,  51-52. 

•  San  Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanislaus  Co.  (1911),  191  Fed. 
875,  881;  Cumberland  T.  &  T.  Co.  vs.  City  of  Louisrille  (1911),  187  Fed.  637; 
Spring  Valley  Waterworks  vs.  City  &  County  of  San  Franeisco  (1911),  192 
Fed.  137;  People  ex  rel.  Kings  Co.  Ltg.  Co.  vs.  Pub.  Serv.  Commn.  (1913),  156 
N.  Y.  App.  Div.  603. 

''Contra  Costa  Water  Co.  vs.  Oakland  (l91l),  159  Cal.  323,  328. 


106 


THE      UTILITIES      MAGAZINE 


the  courts  been  uniform  in  their  opinions  as  to  the 
measure  of  such  depreciation — whether  it  should  cover 
accrued  depreciation  as  well  as  actual,  and  functional 
depreciation  as  well  as  physical. 

The  necessity  for  a  public  utility  to  provide  a  de- 
preciation fund  or  account  is  generally  recognized. 
It  finds  a  foundation  in  efforts  to  equalize  profits  during 
different  years,  so  as  to  avoid  requiring  the  total  cost 
of  improvements  to  appear  as  an  expense  of  the  year 
when  such  improvement  proves  unserviceable.'  The 
necessity,  however,  grows  out  of  broader  considerations 
than  expediency.  It  is  due  to  the  primary  obligations 
of  a  public  utility  to  render  adequate  service  at  rea- 
sonable rates.* 

In  a  private  business,  where  the  owner  may  fix  his 
own  prices  for  the  use  of  his  property,  his  own  interest 
may  compel  him  to  keep  the  property  he  hires  to  others 
up  to  a  standard  that  will  induce  them  to  use  it,  but 
no  one  can  directly  compel  him  to  do  so.  What  interest 
may  force  the  private  owner  to  do  in  respect  of  his  own 
property,  the  law  compels  public  authority  to  do  when 
the  latter  undertakes  to  fix  rates  to  be  charged  by  public 
utilities  corporations.' 

In  fixing  rates,  therefore,  the  ability  of  the  company 
to  meet  these  obligations  must  not  be  impaired.* 

The  question  of  what  are  operating  charges  against 
gross  income  before  reaching  net  income  was  early 
considered  in  several  cases.  In  the  conclusions  reached 
by  the  courts,  the  judges  made  an  intuitive  and  per- 
haps correct  distinction  between  operating  charges  and 
capital  charges,  but  the  reasoning  is  by  no  means  clear.'' 

The  court  explained  the  underlying  necessity  for 
\  providing  against  depreciation  to  be  the  conservation 
\  of  the  security  afforded  by  the  railroad's  property  to 
\    its  creditors  and  the  rendering  of  adequate  service. 

Yet  the  real  significance  of  the  distinction  between 
the  classes  of  charges  is  not  apprehended  by  the  court, 
for  in  the  case  of  United  Stcdes  vs.  Kansas  Pacific 
Railway  Company,^  the  court,  referring  to  the  "princi- 
ples announced"  in  the  earlier  decision,  rejects  an  allow- 
ance for  depreciation  not  actually  expended,  saying:" 

'  Montana,  Wyoming  &  Southern  R.  R.  Co.  vs.  Bd.  of  R.  R.  Commrs.  of  Mont. 
(1912),  198  Fed.  991,  1004. 

*  Perkins  vs.  Northern  Pac.  Ry.  Co.  (1907),  155  Fed.  445,  451. 

»  Cumberland  Td.  &  Tel.  Co.  vs.  City  of  Louisville  (1911),  187  Fed.  637, 
655-656. 

*  Perkins  vs.  Northern  Pac.  Ry.  Co.  (1907),  155  Fed.  445,  451. 

»  Union  Pacific  R.  R.  Co.  vs.  U.  S.  (1878),  99  U.  S.  402, 420;  U.  S.  vs.  Kan- 
sas Pac.  R.  R.  Co.  (1878),  99  U.  S.  455;  St.  John  vs.  Erie  Ry.  Co.  (1874),  89 
U.  S.  136;  N.  Y.  L.  E.  &  W.  R.  R.  Co.  vs.  Nickals  (1886),  119  U.  S.  296; 
Warren  vs.  King  (1883),  108  U.  S.  389;  Mobile  &  0.  R.  R.  Co.  vs.  Stale 
of  Tenn.  (1894),  153  U.  S.  486;  Barnard  vs.  Vermont,  etc.,  R.  R.  Co.  (1863), 
7  Allen  512;  Minot  vs.  Pains  (1868),  99  Mass.  101,  106;  Camden,  etc., 
R.  R.  Co.  vs.  Elkins  (1883),  37  N.  J.  Eq.  273;  Dent  vs.  London  Tramways 
Co.  (1879),  16  Ch.  Div.  844. 

*  (1878),  99  U.  S.  455. 
'P.  459. 


"  'Depreciation  account,  or  expense  not  charged  up.'  This 
is  explained  to  be  the  amount  necessary  to  put  the  road 
in  proper  repair,  but  which  was  not  actually  expended  for 
that  purpose.  We  are  clearly  of  opinion  that  it  is  not  a 
proper  charge.  Only  such  expenditures  as  are  actually 
made  can  with  any  propriety  be  claimed  as  a  deduction  from 
earnings."* 

Clearer  understanding  is  reflected  by  the  subsequent 
court  decisions  with  reference  to  depreciation  allowance 
than  was  reflected  with  reference  to  depreciation  de- 
duction. 

In  rate  regulation,  the  fair  value  basis  was  not  laid 
down  until  the  case  of  Smythe  vs.  Ames,  in  1898,  and  the 
basis  was  not  clearly  understood  until  a  number  of 
years  later  when  successive  decisions  disclosed  a  pre- 
ponderating view.  For  a  considerable  period,  therefore, 
the  relation  of  depreciation  to  the  ascertainment  of 
the  basis  of  return  was  not  defined.  However,  as  the 
validity  of  rates  had  been  attacked  because  of  the  in- 
suflBciency  of  resulting  earnings,  the  importance  of 
determining  the  net  earnings  was  perceived  early,  and, 
in  their  efforts  to  demonstrate  the  insuflBciency  of 
earnings,  the  public  utilities  made  every  charge  against 
gross  earnings  that  could  be  supported  by  reason, 
practice  or  law. 

In  two  cases  decided  in  1896  the  court  recognized 
an  allowance  for  depreciation  not  only  representing 
physical  deterioration  but  also  representing  functional 
depreciation.' 

The  proposition  that  a  depreciation  allowance  should 
be  made  received  a  severe  setback,  in  1897,  in  the  case 
of  San  Diego  Water  Co.  vs.  City  of  San  Diego.^"  Counsel 
for  the  city  contended  that  the  court  erred  in  allowing 
any  percentage  for  "deterioration  of  the  plant,"  and 
the  court  by  a  divided  vote  sustained  this  contention. 
Judge  Fleet  saying: '^ 

"With  regard  to  the  question  of  the  depreciation  of  the 
plant  by  use,  it  is  suflBcient  to  say  that  ordinary  repairs 
should  be  charged  to  current  exjjense,  that  substantial  recon- 
struction or  replacement  should  be  charged  to  the  construction 
account,  and  that  depreciaiion  should  not  otherwise  be  considered. 
It  is  doubtless  difficult  in  many  cases  to  properly  discrim- 
inate between  ciurent  and  ordinary  repairs  and  such  repairs 
as  amount  in  effect  to  new  construction.  Such  difficulties, 
when  they  arise,  must  be  solved  by  the  application  of  the 
principles  on  which  ordinary  business  enterprises  are  con- 
ducted. " 

»See  also  Reagan  vs.  Farmers'  L.  <t  T.  Co.  (1894),  154  U.  S.  362,  407; 
So.  Pac.  Co.  vs.  Bd.  of  R.  R.  Commrs.  of  Cal.  (1896),  78  Fed.  236,  263,  266. 

»  Capital  City  Gas  Light  Co.  vs.  City  of  Des  Moines  (1896),  72  Fed.  829,  848; 
See  also  San  Diego  Land  &  Tovm  Co.  vs.  Natl.  City  (1896),  74  Fed.  79,  184; 
affd.  (1899),  174  U.  S.  789;  San  Diego  Water  Co.  vs.  City  ef  San  Diego  (1897), 
118  Cal.  556. 

"  (1897),  118  Cal.  656. 

"  Pp.  674,  682-588.  This  decision  was  cited  and  followed  in  Redlands, 
etc..  Water  Co.  vs.  Redlands  (1898),  121  Cal.  812. 


DEPRECIATION 


107 


From  the  views  thus  expressed  by  a  majority  of  the 
Court,  Beatty,  C.  J.,  strongly  dissented,  saying:' 

"As  to  current  expenses,  all  operating  expenses  reasonably 
and  properly  incurred  should  be  allowed,  taxes  should  be 
allowed,  and  the  cost  of  current  repairs. 

"In  addition  to  this,  if  there  is  any  part  of  the  plant,  such 
as  main  pipes,  etc.,  which  at  the  end  of  a  term  of  years — 
twenty  years,  for  instance — will  be  so  decayed  and  worn  out 
as  to  require  restoration,  an  annual  allowance  should  be 
made  for  a  sinking  fund  sufficient  to  replace  such  part  of  the 
plant  when  it  is  worn  out. " 

The  same  view  adverse  to  depreciation  allowance 
was  expressed  in  Cedar  Rapids  Water  Company  vs. 
City  of  Cedar  Rapids,^  in  which  an  action  was  brought 
to  restrain  the  enforcement  of  a  city  ordinance  fixing 
water  rates. 

It  may  be  noted,  however,  that  the  California  de- 
cision was  in  effect  reversed  in  Contra  Costa  Water 
Co.'  and  that  the  Iowa  Supreme  Court  reversed  its 
position  in  the  case  of  Cedar  Rapids  Gas  Light  Co.  vs. 
Cedar  Rapids*  as  the  United  States  Supreme  Court 
had  meanwhile  held  in  the  Knoxville  Water  Case  that 
an  allowance  for  depreciation  must  be  made  out  of 
earnings. 

In  1897,  the  Pennsylvania  Supreme  Court,  in  the 
case  of  Brymer  vs.  Butler  Water  Company,^  in  reversing 
an  order  of  the  lower  court  which  fixed,  among  other 
things,  the  rate  for  water  supplied  by  a  water  company 
(under  a  statute  conferring  upon  the  court  visitorial 
powers  with  reference  to  prices  charged  for  water), 
held  that  the  cost  of  the  water  to  the  company  includes 
a  fair  return  to  the  persons  who  furnished  the  capital 
for  the  construction  of  the  plant  "in  addition  to  an 
allowance  annually  of  a  sum  sufficient  to  keep  the  plant 
in  good  repair  and  to  pay  any  fixed  charges  and  operat- 
ing expenses.* 

A  clearer  conception  of  the  subject  was  evinced  in 
Milwaukee  Electric  Railway  &  Light  Company  vs.  City 
of  Milwaukee.'' 

Thus  far,  the  courts  in  their  allowances  for  deprecia- 
tion out  of  earnings  refer,  with  one  exception,  only  to 
physical  depreciation.  That  the  court  would  never- 
theless be  guided  by  expediency  rather  than  by  rule 
was  illustrated  in  the  case  of  the  Metropolitan  Trust 

'P.fi88. 

»  (1902),  118  la.  234,  263. 

»  (1911),  169  Cal.  323. 

♦  (1909).  144  la.  426. 

'  (1897),  179  Pa.  St.  231,  251. 

•This  case  was  followed  in  Wilkes-Barre  vs.  Spring  Brook  Water  Supply  Co. 
(1899),  4  Lack.  Leg.  News  367,  where,  however,  only  1  per  cent  was  al- 
lowed, and  was  cited  with  approval  in  Long  Branch  Commn.  vs.  Tintem 
Manor  Water  Co.  (1905),  70  N.  J.  Eq.  71,  82. 

'  (1898),  87  Fed.  577,  682. 


Company  of  New  York  vs.  Houston  &  Texas  Central 
Railroad  Company.^ 

By  1899,  the  rule  of  depreciation  allowance  had 
become  recognized  and  established.  From  1899  to 
1909,  there  were  a  number  of  cases  in  which  it  was  held 
that  a  depreciation  allowance  must  be  made  to  ascer- 
tain the  net  earnings  attributable  to  the  return  under  a 
given  rate,  but  they  make  reference  only  to  physical 
depreciation  or  deterioration  but  not  to  functional 
depreciation.* 

It  was  not  until  the  decision  was  rendered  by  the 
United  States  Supreme  Court  in  the  City  of  Knoxville 
vs.  Knoxville  Water  Company,^"  upon  an  appeal  involving 
the  validity  of  water  rates  fixed  by  the  municipality, 
that  all  doubts  upon  the  right  of  the  utility  to  have 
allowance  made  out  of  revenues  for  depreciation  before 
arriving  at  the  return  to  which  a  public  is  entitled,  were 
resolved.  In  that  case,  upon  this  phase  of  depreciation. 
Judge  Moody  said:" 

"  Before  coming  to  the  question  of  profit  at  all  the  company 
is  entitled  to  earn  a  sufficient  sum  annually  to  provide  not 
only  for  current  repairs  but  for  making  good  the  depreciation 
and  replacing  the  parts  of  the  property  when  they  come  to 
the  end  of  their  life.  The  company  is  not  bound  to  see  its 
property  gradually  waste,  without  making  provision  out  of 
earnings  for  its  replacement.  It  is  entitled  to  see  that  fro7n 
earnings  the  value  of  the  property  invested  is  kept  unimpaired, 
so  that  at  the  end  of  any  given  term  of  years  the  original 
investment  remains  as  it  was  at  the  beginning.  It  is  not 
only  the  right  of  the  company  to  make  such  a  provision,  but 
it  is  its  duty  to  its  bond-  and  stockholders,  and,  in  the  case  of  a 
public  service  corporation  at  least,  its  plain  duty  to  the  public. 
If  a  different  course  were  pursued  the  only  method  of  provid- 
ing for  replacement  of  property  which  has  ceased  to  be  useful 
would  be  the  investment  of  new  capital  and  the  issue  of  new 
bonds  or  stocks.  This  course  would  lead  to  a  constantly 
increasing  variance  between  present  value  and  bond  and 
stock  capitalization — a  tendency  which  would  inevitably 
lead  to  disaster  either  to  the  stockholders  or  to  the  public, 
or  both.  If,  however,  a  company  fails  to  perform  this  plain 
duty  and  to  exact  sufficient  returns  to  keep  the  investment 
unimpaired,  whether  this  is  the  result  of  unwarranted  divi- 
dends upon  over-issues  of  securities,  or  of  omission  to  exact 
proper  prices  for  the  output,  the  faidt  is  its  own.  When, 
therefore,  a  public  regulation  of  its  prices  comes  under  ques- 
tion the  true  value  of  the  property  then  employed  for  the 

»  (1898),  90  Fed.  683,  690. 

•  City  of  Grand  Haven  vs.  Grand  Haven  Water  Works  (1899),  119  Mich.  652; 
San  Diego  Land  &  Tovm  Co.  vs.  NaU.  City  (1899),  174  U.  S.  739,  757;  San 
Diego  Land  &  Tovm  Co.  vs.  Jasper  (1903),  189  U.  S.  439,  446;  Spring  Valley 
Water  Works  vs.  City  &  County  of  San  Francisco  (1903),  124  Fed.  574,  599; 
Stanislaus  Co.  vs.  San  Joaquin  C.  &.  I.  Co.  (1904),  192  U.  S.  201,  215,  revg. 
s.c.  (1902),  113  Fed.  930;  Perkins  vs.  Northern  Pae.  Ry.  Co.  (1907),  155  Fed. 
445,  451;  San  Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanislaus  (1908), 
163  Fed.  567,  572;  Spring  Valley  Water  Co.  vs.  City  <fc  Co.  of  San  Francisco 
(1908).  165  Fed.  667,  702-704. 

>•  (1909),  212  U.  S.  1. 

1  P.  13. 


108 


THE      UTILITIES      MAGAZINE 


purpose  of  earning  a  return  cannot  be  enhanced  by  a  consid- 
eration of  the  errors  in  management  which  have  been  com- 
mitted in  the  past. " 

The  decision,  while  emphatically  holding  that  a 
depreciation  allowance  should  be  made,  is  ambiguous 
upon  the  question  whether  the  allowance  should  cover 
functional  as  well  as  physical  depreciation. 

Following  the  Knoxville  decision,  there  were  a  few 
decisions  in  which  a  depreciation  allowance  was  allowed, 
without  any  indication  by  the  court  as  to  whether 
functional  depreciation  should  be  included,'  but  the 
principal  cases  since  1909  not  only  recognize  that  the 
depreciation  allowance  should  include  accrued  as  well 
as  actual  depreciation,  but  also  hold  that  it  should 
include  provision  for  obsolescence,  inadequacy  and 
other  functional  depreciation.  Indeed,  the  prepon- 
derance of  opinions  since  the  Knoxville  Case  is  in  that 
direction.  In  this  regard,  the  inclusion  of  functional 
depreciation  in  the  depreciation  allowance  contrasts 
sharply  with  the  deduction  for  depreciation  from  re- 
production cost. 

Soon  after  the  Knoxville  decision,  the  Iowa  Supreme 
Court,  in  the  rate  case  of  Cedar  Rapids  Gas  Light 
Company  vs.  Cedar  Rapids,  limited  the  allowance  to 
physical  depreciation  and  refused  to  make  an  allow- 
ance for  functional  depreciation.^ 

Upon  appeal,  the  United  States  Supreme  Court  held 
that  while  the  court  "perhaps  should  have  adopted  a 
rule  as  to  depreciation  somewhat  more  favorable  to 
the  plaintiff,"  there  was  nothing  that  the  Court  could 
take  notice  of  to  warrant  a  change  in  the  result.' 

A  clear  trend  in  the  direction  of  allowing  for  functional 
depreciation  was  marked  by  the  Federal  Court,  in  1911, 
upon  a  final  hearing  in  the  case  of  Cumberland  Tel.  & 
Tel.  Company  vs.  City  of  Louisville.* 

One  of  the  leading  decisions  on  rate  regulation,  in 
which  the  subject  of  depreciation  is  extensively  dis- 
cussed, is  that  of  Pioneer  Tel.  &  Tel.  Company  vs. 
Westenhaver,*  and  the  court  there  fully  recognizes 
functional  causes  as  elements  in  the  amount  that  should 
be  allowed  from  earnings  for  depreciation. 

That  the  depreciation  allowance  should  include  the 
/  elements  of  functional  depreciation  was  even  more 
[  strongly  expressed  in  Spring  Valley  Waterworks  vs. 
1     City  of  San  Francisco.^ 

»  Tmtchell  vs.  City  of  Spokane  (1909),  55  Wash.  86,  89;  Contra  Coala  Water 
Co.  vs.  Oakland  (1911),  159  Cal.  323,  336-337;  San  Joaquin  &  Kings  R. 
Canal  &  Irr.  Co.  vs.  Stanislaus  (1911),  191  Fed.  875,  886,  887,  reversed  in 
S.C.  (1914),  223  U.  S.  454. 

«  (1909),  144  Iowa,  426,  444,  445^46. 

>  Cedar  Rapids  Gas  Co.  vs.  C.  R.  (1912),  223  U.  S.  655,  670;  See  also  Home 
Tel.  Co.  vs.  City  of  Carthage  (1911),  235  Mo.  644,  665-666;  Puget  Sound  Elec. 
Ry.  Co.  vs.  R.  R.  Commn.  of  Wash.  (1911),  65  Wash.  76,  81-82. 

*  (1911),  187  Fed.  637.  654. 

»  (1911),  29  Okla.  429;  451,  453-454. 

•  (1011).  192  Fed.  187.  184. 


The  disposition  of  the  courts  is  in  favor  of  a  liberal 
allowance  as  is  reflected  in  the  decision  in  Home  Tele- 
phone Company  vs.  City  of  Carthage.'' 

The  courts  have  often  confessed  the  difficulty  of 
determining  the  amount  of  depreciation  allowance.' 

The  public  utility  is  not  entitled  to  have  any  allow- 
ance made  in  the  annual  fixing  of  rates  to  cover  any 
past  depreciation.' 

The  allowance  for  depreciation  reserve  should  not 
be  used  for  additions  to  capital  account,  to  be  included 
in  the  fair  value  of  property  as  a  basis  of  return." 

In  Louisville  &  Nashville  R.  R.  Co.  vs.  Railroad  Com- 
mission of  Alabama,^^  the  special  master  rejects  the 
contention  by  the  Railroad  Commission  that  in  deter- 
mining current  income,  interest  should  be  allowed  on 
the  balance  in  the  replacement  account. 

The  straight  line  method  of  determining  depreciation 
allowance  is  generally  used.'' 

It  is  settled  that  accrued  depreciation  should  be 
deducted  from  the  valuation  and  should  be  allowed 
in  computing  earnings,  but  as  previously  remarked, 
while  there  is  not  yet  a  preponderance  of  decisions  in 
favor  of  the  inclusion  of  functional  depreciation  in  the 
deduction,  the  trend  of  authorities  since  the  Knoxville 
Case  is  in  favor  of  the  allowance  for  functional  depreci- 
ation out  of  earnings. 

The  purposes  of  depreciation  deduction  and  depreciar 
tion  allowance  are  different,  for  in  the  case  of  deduction 
from  reproduction  value  it  has  been  used  for  determin- 
ing the  amount  of  property  within  the  constitutional 
guarantee,  while  in  the  case  of  depreciation  allowance 
out  of  earnings  it  has  been  used  for  assuring  the  con- 
servation of  the  investors'  capital  and  the  maintenance 
of  the  plant's  operating  continuity  and  efficiency.  It 
may  be  that,  viewing  the  problem  without  regard  to 
the  constitutional  guarantee,  but  from  the  standpoint 
of  equitable  consideration,  it  should  not  be  necessary 
to  include  functional  depreciation  and  even  accrued 
depreciation  in  order  to  reach  a  fair  basis  of  return.     In 

'  (1911),  235  Mo.  644,  666. 

•  Spring  Valley  Wafer  Works  vs.  City  and  County  of  San  Francisco  (1911), 
192  Fed.  137,  185;  Pioneer  Tel.  &  Tel.  Co.  vs.  Westenhaver  (1911),  29  Okla. 
429,  453;  Cumberland  Td.  &  Tel.  Co.  vs.  City  of  Louisville  (1911),  187  Fed. 
637,  653;  Puget  Sound  Elec.  R.  vs.  Railroad  Commn.  (1911),  65  Wash.  75,  83; 
Uncoln  Gas  &  Elec.  Lt.  Co.  vs.  City  of  Uncoln  (1912),  223  U.  S.  349,  363. 

»C%  of  Knoxville  vs.  KnoxvUle  Water  Co.  (1909),  212  U.  S.  1,  14;  Contra 
Costa  Water  Co.  vs.  Oakland  (1911),  159  Cal.  323,  338;  Puget  Sound  El.  Ry. 
Co.  vs.  R.  R.  Commn.  of  Wash.  (1911),  65  Wash.  75,  81-82. 

»»Io.  R.  R.  Commn.  vs.  Cumberland  T.  &  T.  Co.  (1909).  212  U.  S.  414, 
424,  425. 

"  (1911),  U.  S.  Circuit  Court,  Middle  District  of  Alabama,  Report  of 
William  A.  Gunter,  Special  Master  in  Chancery;  s.c.  appd.  (1912),  196  Fed. 
800. 

«  Cumberland  Tel.  &  Tel.  Co.  vs.  City  ofLouisvUle  (1911),  187  Fed.  637, 655; 
Louismlle  &  Nashville  R.  R.  Co.  vs.  R.  R.  Commrs.  of  Alabama  (1911),  U.  S. 
Cu-cuit  Court,  Middle  Dist.  of  Alabama,  Report  of  Wm.  A.  Gunter,  Special 
Master  in  Chancery. 


DEPRECIATION 


109 


that  connection,  other  factors  would  have  to  be  con- 
sidered. 

DEPRECIATION  AS  A  FACTOR  IN  DETERMI- 
NATION OF  VALUE  IN  CONDEMNATION 
AND  PURCHASE  CASES 

The  value  of  property  for  rate  purposes  is  in  several 
essentials  different  from  that  for  purchase  and  con- 
demnation. A  rule  of  valuation  might  be  adopted  in 
a  condemnation  case  which  would  not  work  in  a  rate 
case.' 

The  authorities  in  condemnation  and  purchase  cases 
have  deducted  depreciation  to  determine  physical 
value.^ 

In  Newburyport  Water  Co.  vs.  Newburyport,  the 
Commissioners  of  Appraisal  of  the  fair  value  of  water 
property  acquired  by  the  city  pursuant  to  statute 
adopted  among  the  "elements  of  valuation"  the  "cost 
of  reproduction  of  all  that  part  of  the  physical  plant 
used  in  pumping  and  delivering  water,  less  any  depreci- 
ation. "  This  method  was  employed  without  objection 
by  all  the  experts  who  testified,  and  Judge  Holmes,  for 
the  court,  accepted  the  commissioners'  award. 

This  rule  was  followed  in  Gloucester  Water  Supply 
Co.  vs.  Gloucester. 

In  Kennebec  Water  District  vs.  Waterville,^  a  leading 
case  on  the  subject.  Judge  Savage  held  that,  while 
"the  actual  cost  of  the  plant  and  property  together 
with  proper  allowances  for  depreciation"  was  "compe- 
tent evidence "  upon  the  question  of  the  present  value 
of  them,  it  was,  however,  "not  conclusive." 

Thus  far  nothing  has  been  declared  by  the  court  as 
to  the  elements  to  be  included  in  depreciation,  but  in 
1902,  in  the  Holyoke,  Mass.,  purchase  case,  the  court 
held  that  functional  depreciation  should  be  included 
in  the  deduction  of  depreciation  from  the  reproduction 
cost.^ 

The  question  of  what  method  should  be  adopted  in 
calculating  the  depreciation  is  not  discussed  in  the 
purchase  and  condemnation  cases,  perhaps  because 
the  courts  have  used  the  same  method  that  was  used 
either  by  the  public  utility  or  in  the  decisions  involving 
depreciation   in   relation   to    rate    determination.     A 

^Spring  Valley  Water  Works  vs.  San  Francisco  (1911),  192  Fed.  137,  155; 
Peo.  ex  rel.  Kings  County  Lighting  Co.  vs.  Public  Service  Commission  (1913), 
156  App.  Div.  603. 

'Newburyport  Water  Co.  vs.  Newburyport  (1897),  168  Mass.  543,  544; 
Ohucester  Water  Supply  Co.  vs.  Gloucester  (1901),  179  Mass.  365. 

»  (1902),  97  Me.  185,  207. 

*  The  report  of  the  commissioners  was  confirmed  by  the  court  with  the 
consent  of  both  parties,  November  18,  1902.  For  an  abstract  of  the  report 
of  the  commissioners,  see  Massachusetts  Gas  and  Electric  Light  Commission- 
ers, Annual  Report,  1903,  pp.  77-82.  Functional  depreciation  as  an  element 
as  of  accrued  depreciation  was  rejected  in  an  English  purchase  case  of  some 
importance.  Natiomd  Telephone  Co.,  Ltd.,  vs.  His  Majesty's  Postmaster- 
General.  (1913),  16  A.  T.  &  T.  Co.  Com.  L.  491,  536.  538  (Sir  James 
Woodhouse,  Court  of  Railway  and  Canal  Commission). 


recent    English    case,   after   discussing   this   question, 
adopted  the  straight  line  method.* 

We  find  little  discussion  of  the  subject  of  depreciation 
in  condemnation  and  purchase  cases,  and  there  is  yet 
no  preponderance  as  to  the  measure  of  depreciation  to 
be  applied  although  the  trend  in  this  country  is  toward 
including  functional  depreciation  as  an  element  of 
accrued  depreciation. 

DEPRECIATION  AS  A  FACTOR  IN  TAX  CASES 

Depreciation  as  a  factor  in  tax  cases  has  been  re- 
cently discussed  in  the  New  York  franchise  tax  cases 
which  furnish  the  inspiration  of  the  advanced  views 
on  this  subject  expressed  in  various  relations. 

It  should  be  noted,  however,  that  the  decisions  in 
tax  cases  do  not  give  the  subject  such  precise  considera- 
ation  as  in  rate  cases,  because  it  is  not  certain  what 
weight  tax  oflBcials  give  to  the  several  elements  of  their 
valuation.  It  is  not  necessary  in  valuing  a  property 
as  a  totality  for  taxation  to  disintegrate  the  various 
elements  which  enter  into  it  and  ascribe  to  each  its 
separate  fraction  of  valuation."  In  taxation  cases,  the 
problem  of  valuation  is  different  from  that  in  rate 
cases,  because  in  the  former  the  fair  value  is  the  basis, 
whereas  in  the  latter  actual  value  is  the  basis. 

Whether  any  deduction  on  account  of  depreciation 
should  be  made  from  the  value  of  the  property,  in 
these  cases,  is  not  clear.' 

In  computing  operating  expenses,  the  judges  have 
held  that  the  utility  company  is  entitled  "to  set  aside 
each  year  from  its  earnings  a  reasonable  sum  to  provide 
for  its  [property]  replacement."^ 

The  Supreme  Court  of  New  York  strongly  emphasizes 
functional  depreciation  as  an  element,  saying:' 

"As  surely  as  humanity  travels  to  the  grave,  the  machinery 
and  equipment  of  a  public  service  corporation  travel  toward 
the  scrap  pile.  The  plant  and  structures  depreciate  in  less 
degree,  but  as  certainly.     This  is  ordinary  depreciation. 

"  But  another  form  of  depreciation  in  the  case  of  properties 
here  being  valued  takes  place.  The  machinery  or  equipment, 
while  still  capable  of  years  of  service,  becomes  inadequate 
to  do  the  work  demanded — not  only  by  the  corporation  but 
by  the  law  itself.  In  the  case  particularly  of  electrical 
machinery,  the  type  becomes  obsolete  by  reason  of  invention, 
and  increasing  pubUe  demands  frequently  require  in  aid  of 

'  Natl.  T.  Co.  vs.  His  Majesty's  P.  M.  Genl.  (1913),  16  A.  T.  &  T.  Co.  L. 
491,  538. 

•  Peo.  ex  rel.  Brooklyn  City  Railroad  Company  vs.  New  York  State  Board  of 
Tax  Commissioners  (1905),  199  U.  S.  48. 

'  People  ex  rel.  Third  Av.  R.  R.  Co.  vs.  State  Bd.  of  Tax  Commrs.  (1909),  136 
N.  Y.  App.  Div.  154,  affd.  198  N.  Y.  608. 

«  People  ex  rel.  3rd  Av.  R.  R.  Co.  vs.  State  Bd.  of  Tax  Commrs.  (1909),  136  N. 
Y.  App.  Div.  154,  affd.  198  N.  Y.  608;  Peo.  ex  rel.  Jamaica  Water  Supply  Co. 
vs.  Tax  Commrs.  (1909),  196  N.  Y.  39,  58-59. 

'  Peo.  ex  rel.  Brooklyn  Heights  R.  R.  Co.  vs.  State  Board  of  Tax  Commrs. 
(1910),  69  Misc.  646,  657,  669. 


110 


THE      UTILITIES      MAGAZINE 


safe  and  adequate  service  that  the  obsolete  appliance  or 
equipment  give  way  to  the  new.  .  .  .  This  would  appear 
to  be  a  legislative  recognition  of  the  systems  adopted  provid- 
ing for  the  charge,  out  of  income,  of  items  for  obsolescence 
and  inadequacy,  upon  a  plan  which  apparently,  according 
to  the  State,  was  reasonably  capable  of  ascertainment  from 
the  experience  of  the  corporation  itself. 

"The  policy  of  the  State  to-day,  so  reflected  by  statute,  is 
in  favor  of  these  charges  out  of  earnings.  .  .  .  The 
corporations  must  provide  under  the  present  statute  safe 
and  adequate  service.  Upon  this  the  statute  is  insistent  and 
the  higher  power  has  been  conferred  upon  the  Commission 
to  see  that  this  provision  of  the  law  is  complied  with. 

"To  provide  safe  and  adequate  service  is  not  to  maintain 
old  and  obsolete  cars  even  though  by  constant  repair  they 
may  be  kept  from  dissolution.  It  is  to  keep  in  touch  with 
the  times,  and  to  displace  obsolete  or  inadequate  appliances 
or  structures  with  new  and  approved  appliances.  These 
expenditures  come  suddenly  in  some  cases— in  others  their 
approach  may  be  apprehended. "' 

The  straight  line  method,  rather  than  the  sinking 
fund  method,  of  computing  depreciation  has  been 
adopted  in  these  franchises  tax  cases.* 

These  cases  leave  no  doubt  that  depreciation  allow- 
ance out  of  earnings  should  make  provision  for  accrued 
depreciation  and  for  functional  depreciation.  The  ques- 
tion as  to  what  are  net  earnings  is  the  same  in  a  fran- 
chise tax  case  as  in  a  rate  case,  because  the  same  credits 
and  debits  are  made.  Therefore,  the  measure  of  de- 
preciation allowances  out  of  earnings  applied  in  fran- 
chise tax  cases  is  equally  applicable  in  principle  in 
rate  cases  with  reference  to  the  ascertainment  of  earn- 
ings attributable  to  the  return. 

DEPRECIATION  AS  A  FACTOR  IN 
ACCOUNTING 

The  United  States  Supreme  Court  has  well  stated: 

"Since  the  regulation  of  the  railroad  carrier  by  the  public 
authority,  and  especially  the  fixing  of  rates  to  be  charged, 
depend  primarily  upon  two  fundamental  considerations:  (a) 
the  value  of  the  property  that  is  employed  in  the  public 
service,  and  (b)  the  current  cost  of  carrying  on  that  service, 
it  is  clear  that  the  maintenance  of  a  proper  line  of  distinction 
between  property  accounts  and  operating  accounts  is  essen- 
tial to  the  execution  by  the  Interstate  Commerce  Commission 
of  the  supervisory  and  regulatory  powers  conferred  upon  it 
by   Congress."' 

The  early  failure  to  recognize  the  factor  of  deprecia- 
tion was  accompanied  by  its  neglect  in  the  accounts 
of  utilities.     In  the  regulation  of  public  utilities,  uni- 

'  To  the  same  effect,  see  People  ex  rd.  Queens  Co.  Water  Co.  vs.  Wood- 
bury, decided  in  1910,  Blackmar,  J.  (1910)  07  Misc.  490,  493,  affd.  143 
A.  D.  618,  affd.  without  opinion,  202  N.  Y.  619. 

2  Peo.  ex  rel.  Manhattan  Railway  Co.  vs.  Woodbury  (1911),  203  N.  Y.  231. 

'  Kansas  City  Southern  Ry.  Co.  vs.  U.  S.  (1913),  281  U.  S.  423,  445,  affd. 
204  Fed.  641. 


formity  of  accounts  and  the  application  of  correct 
accounting  principles  to  ascertain  the  true  financial 
situation  of  the  utility  are  conspicuous  features  be- 
cause they  are  important  to  the  public,  the  corporate 
management,  and  the  investors.  Systems  of  accounts 
have  been  formulated  by  regulatory  boards  for  the 
purpose  of  insuring  the  integrity  of  "capital"  and  the 
correctness  of  the  charges  to  "cost  of  operation."* 

As  an  operating  charge,  depreciation  must  be  given 
due  attention  in  the  company's  accounts.  It  has  been 
suggested  that,  if  a  company  does  not  reserve  a  suffi- 
cient portion  of  its  revenue  to  replace  capital  consumed 
during  the  year  but  not  requiring  replacement  within 
the  year,  and  then  proceeds  to  treat  the  entire  surplus 
as  divisible  profits,  it  is  actually  violating  the  criminal 
statute,  such  as  there  is  in  New  York,  against  the 
declaration  of  dividends  out  of  capital  just  as  effec- 
tually as  though  it  sold  stock  and  distributed  the 
proceeds  immediately  in  the  form  of  dividends.' 

Depreciation  accounts  have  a  vital  and  direct  rela- 
tion to  income  bonds  and  mortgages  issued  by  public 
utilities,  because  interest  cannot  be  paid  until  all 
operating  charges  have  been  met.' 

"The  distinction  between  ordinary  repairs  and  repairs 
made  in  ordinary  reconstruction  of  the  plant  may  not  be 
acciu-ately  drawn,  but  absolute  accuracy  is  not  required  in 
such  details."' 

Whether  depreciation  charges  upon  the  accounts 
of  a  public  utility  should  include  also  obsolescence  and 
inadequacy  was  decided  in  Kansas  City  Southern  Rail- 
way Company  vs.  United  States.^  The  orders  of  the 
Interstate  Commerce  Commission,  establishing  a  uni- 
form system  of  accounts,  required  the  deduction  from 
the  cost  of  additions  and  betterments  of  the  value  or 
estimated  value,  less  salvage,  of  property  abandoned 
and  the  charging  of  the  value  or  estimated  value,  less 
salvage,  of  the  property  abandoned  to  operating  ex- 
penses. The  carrier's  contention,  said  the  Supreme 
Court,  per  Pitney,  J., 

"will  be  found,  upon  analysis,  to  rest  upon  the  unwarrantable 
assumption  that  all  capital  expenditures  result  in  permanent 
accretions  to  the  property  of  the  company.     This  in  effect 

*  Maltbie  Conunr.,  In  re  Uniform  System  of  Accomits  1  P.  S.  C.  R.,  1st 
Dist.  N.  Y.  756,  777;  People  ex  rel.  Brooklyn  His.  R.  R.  Co.  vs.  Tax  Commrs. 
(1910).  69  Misc.  646,  567-658. 

•  Maltbie,  Commr.,  re  Metropolitan  Street  Railway  Co.  Reorganization 
(1912),  3  P.  S.  C.  R.,  Ist  Dist.  N.  Y.  113,  131. 

'  Re  Metropolitan  Street  Ry.  Co.  Reorganization  (1912),  8  P.  S.  C.  R.,  Ist 
Dist.  N.  Y.  113,  131.  See,  in  this  connection,  a  case  pending  in  the  courts 
upon  a  certiorari  of  the  Commission's  order  for  a  depreciation  reserve: 
Re  amortization  account  of  Third  Avenue  Railway  Company  (1912),  3 
P.  S.  C.  R.,  Ist  Dist.  N.  Y.  51;  re  Metropolitan  Street  Railway  Company 
Reorganization  (1912),  3  Id.  113;  re  depreciation  account  of  New  York 
RaUways  Co.,  6  P.  S.  C.  R.,  1st  Dist.  N.  Y.,  advance  sheets,  July,  1915. 

'  San  Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanislaus  (1911),  Fed.  875,  887. 

«  (1913),  231  U.  S.  423,  affg.  204  Fed.  641. 


DEPRECIATION 


111 


ignores  depreciation — an  inevitable  fact  which  no  system  of 
accounts  can  properly  ignore.  A  more  complete  depreciation 
than  that  which  is  represented  by  a  part  of  the  original  plant 
that  through  destruction  or  obsolescence  has  actually  perished 
as  useful  property,  it  would  be  diflScult  to  imagine.  The 
fact  that  the  original  investment  was  necessary  in  order  that 
the  second  investment  might  be  made  is  not  a  conclusive 

test 

"And  since  one  of  the  manifest  objects  of  Congress  is 
authorizing  the  supervision  and  standardization  of  carriers' 
accounts  ....  was  to  enable  the  Commissioners 
to  intelligently  perform  their  duties  respecting  the  regulation 
of  carriers'  rates  for  the  service  performed,  and  since  it  is 
settled  that  the  property  investment  which  is  to  be  taken 
into  consideration  as  one  of  the  elements  in  fixing  such  rates 
is  the  property  then  in  use  [citing  cases],  it  is  obvious  that 
so  far  as  the  regulations  of  the  Commission  now  under  con- 
sideration discard  the  'cost  of  progress'  theory,  they  need  no 
further  vindication." 

In  its  relation  to  accounts,  the  court  has  therefore 
applied  functional  as  well  as  physical  depreciation  and 
accrued  as  well  as  actual  depreciation. 

DEPRECIATION  AS  A  FACTOR  IN  CAPITAL- 
IZATION 

The  growth  of  public  utility  regulation  and  its  ex- 
tension to  capitalization  have  added  a  very  important 
class  of  cases  involving  the  factor  of  depreciation. 

The  primary  object  of  regulating  capitalization  was 
to  correct  the  evils  of  the  imposition  upon  the  public 
by  the  issues  of  stocks  and  bonds  of  public  service 
corporations  for  improper  purposes,  without  actual 
consideration  therfefor,  by  corporation  officers  seeking 
to  enrich  themselves  at  the  expense  of  innocent  confid- 
ing investors.!  But  the  financial  disasters  which  over- 
took a  number  of  public  utilities  disclosed  that  a  greater 
evil  lay  in  the  capitalization  of  the  cost  of  property 
used  not  as  additions  to  capital,  but  as  replacements, 
and  in  the  failure  to  provide  a  depreciation  reserve  to 
cover  such  replacements. 

In  People  ex  rel.  Binghampton  Light,  Heat  &  Power 
Co.  vs.  Public  Service  Commission,'^  upon  certiorari  to 
review  an  order  of  the  second  District  Commission 
denying  an  application  in  part  for  the  approval  of  an 
issue  of  bonds  to  refund  indebtedness,  although  the 
Court  of  Appeals  reversed  the  determination  of  Com- 
mission, it  said: 

"A  reasonable  consideration  of  the  interests  of  a  corpora- 
tion and  the  ultimate  good  of  its  stock  and  bondholders,  and 
a  regard  for  the  investing  pubhc  and  that  fair  dealing  which 
should  be  observed  in  all  business  transactions,  require  that 
machines  and  tools  paid  for  and  charged  to  capital  account 
but  which  necessarily  become  obsolete  or  wholly  worn  out 
within  a  period  of  years  after  the  same  are  purchased  or 

'  Peo.  ex  rel.  Delaware  &  Hudson  Co.  vs.  Stevens  (1011),  197  N.  Y.  1. 
«  (1911),  203  N.  Y.  7. 


installed  should  be  renewed  or  replaced  by  setting  aside  from 
time  to  time  an  adequate  amount  in  the  nature  of  a  sinking 
fund  or  that  by  some  other  system  of  financing  the  corpora- 
tion put  upon  the  purchaser  from  the  corporation  the  expense 
not  alone  of  the  daily  maintenance  of  the  plant  but  a  just 
proportion  of  the  expense  of  renewing  and  replacing  that 
part  of  the  plant  which,  although  not  daily  consumed,  must 
necessarily  be  practically  consumed  within  a  given  time. " ' 

In  People  ex  rel.  Westchester  Electric  Railroad  Com- 
pany vs.  Public  Service  Commission,*  upon  a  certiorari 
to  reverse  an  order  of  the  Second  District  Commission 
disapproving  in  part  an  application  for  approval  of  an 
issue  of  stock  pursuant  to  a  reorganization  plan  upon 
foreclosure,  the  Commission  having  made  a  valuation 
of  the  property,  the  Appellate  Division  in  reversing 
the  Commission's  order  said  (Kellogg,  J.) : 

"It  was  proper  to  deduct  from  the  estimated  reproductive 
cost  proper  depreciation  resulting  from  age  and  use;  also,  if 
age  and  use  in  any  way  depreciated  the  property,  that  should 
have  been  considered. " 

The  courts  have  not  indicated  the  measure  of  non- 
capitalizable  depreciation.  Salutary  results  have  been 
accumulating  of  the  observance  of  the  rules  laid  down 
with  regard  to  the  depreciation  element  affecting  capi- 
talization. 

CONCLUSION 

The  importance  of  distinguishing  between  the  various 
purposes  of  depreciation  has  not  been  grasped.  In 
the  earlier  rate  cases,  growing  out  of  state  or  local  legis- 
lation or  out  of  determinations  by  supervising  officials, 
usually  without  adequate  investigation  of  relevant 
data,  the  public  utilities  were  obliged  to  invoke  the 
aid  of  the  courts  to  prevent  the  confiscation  of  their 
property  rights,  and  in  the  decision  of  that  question 
the  court's  first  inquiry  was:  "What  are  the  property 
rights.?"  As  property  which  by  expiration  had  ceased 
to  exist  could  not  be  the  subject  of  confiscation,  the 
courts,  with  the  only  object  of  determining  what 
property  rights  were  affected,  soon  adopted  the  method 
of  reproduction  cost  less  depreciation  for  ascertaining 
what  the  property  was. 

Depreciation  deduction  was,  therefore,  confined  to 
actual  depreciation.  When,  however,  the  question 
of  earnings  came  to  be  considered,  a  new  light  was  cast 
upon  the  subject.  The  duty  and  importance  of  pro- 
viding out  of  earnings  against  the  impairment  of  the 
capital  invested,  and  for  the  maintenance  of  the  integ- 
rity of  the  plant  for  continuous  and  efficient  service, 
was  already  realized.  In  this  relation  functional  de- 
preciation and  accrued  depreciation  received  recogni- 
tion.   The  failure  to  distinguish  between  the  different 

'  Applied  in  Peo.  ex.  rel.  D.  D.  E.  B.  &  C.  R.  R.  Co.  vs.  Public  Service  Com- 
mission (1915),  167  App.  Div.  286,  303. 
♦  (1913),  168  App.  Div.  251,  affd.  210  N.  Y.  456.  211 N.  Y.  533. 


112 


THE      UTILITIES      MAGAZINE 


purposes  of  depreciation  soon  brought  about  a  confusion 
as  to  the  measure  of  depreciation  which  should  be 
applied  to  the  different  purposes,  and  the  expressions 
used  in  the  case  of  one  were  applied  to  the  other. 
But  it  should  be  borne  in  mind  that  in  the  earlier  rate 
cases  the  courts  were  concerned  purely  with  the  ques- 
tion of  whether  the  result  under  the  rate  was  confisca- 
tion of  property  rights  or  denial  of  equal  protection. 
Regulating  bodies,  however,  are  not  confined  to  the 
narrow  question  of  confiscation. 


The  courts  in  reviewing  orders  of  public  service  com- 
missions are  likewise  not  confined  to  that  question. 
Not  thus  limited  in  their  review,  the  courts,  in  appeals 
from  decisions  of  Conamissions,  have  greater  oppor- 
tunity for  meeting  the  much  felt  need  of  a  definition  of 
depreciation  in  order  that  we  may  understand  its  scope 
in  any  aspect,  and  the  formulation  of  rules  as  to  the 
measure  to  be  applied  to  particular  classes  of  cases  in 
order  that  each  class  may  be  governed  by  the  principles 
peculiar  to  it. 


DEPRECIATION  AND  ITS  RELATION  TO  THE  FAIR  VALUE 


By  HaIiFord   Eeickson 

Chairman,  Wisconsin  Railroad  Commission 


THIS  paper  deals  with  depreciation  and  its  rela- 
tion to  the  fair  value  in  the  appraisal  of  the 
physical  property  of  public  utilities.  The 
treatment  that  should  be  accorded  accrued  depreciation 
in  determining  the  fair  value  of  such  property  is  a 
subject  upon  which  much  is  written  to-day  and  con- 
cerning which  there  are  about  as  many  opinions  as 
there  are  writers.  The  methods  under  which  accrued 
depreciation  and  the  fair  value  of  such  property  are 
now  determined  do  not  as  yet  appear  to  be  as  well  de- 
veloped or  settled  as  many  who  in  one  way  or  another 
are  interested  in  such  appraisals  would  wish  them  to  be. 
The  subject  is,  indeed,  a  broad  one.  It  enters  into  and 
is  a  part  of  nearly  all  of  the  more  important  questions 
that  are  connected  with  such  appraisals.  It  is  so 
comprehensive  in  fact  that  it  cannot  be  fully  dis- 
cussed in  one  short  paper.  In  this  paper,  therefore, 
no  attempt  is  made  to  cover  the  entire  field.  This 
paper  is,  in  fact,  limited  to  a  brief  discussion  of  the 
nature  of  the  terms,  fair  value  and  depreciation,  and 
to  how,  in  the  light  of  the  facts  and  principles  involved, 
accrued  depreciation  and  the  balances  in  the  deprecia- 
tion reserve  should  be  treated  in  determining  the  fair 
value  of  public  utilities. 

FAIR  VALUE 

The  fair  value  of  public  utility  property,  when  these 
utilities  are  operating  under  normal  conditions,  may  be 
defined  as  the  normal  cost  of  obtaining  the  capital  or 
property  needed.  This  definition  or  basis  is  taken 
from  the  competitive  field.  Value  originates  in  the 
wants  of  man.  These  wants  may  be  satisfied  by  com- 
modities and  service.  Commodities  and  services  which 
satisfy  such  wants  are  said  to  possess  utility  and  are 
much  sought  after.  When  such  commodities  are  scarce 
and  cannot  be  had  without  labor  or  sacrifices  of  some 


kind,  they  are  also  said  to  have  value.  Value  is 
usually  said  to  be  of  two  kinds — subjective  and  ob- 
jective. Subjective  value  is  the  value  attached  to  a 
thing  by  an  individual.  Objective  value  is  the  so-called 
exchange  value  or  the  price  at  which  goods  and  services 
are  exchanged  in  the  market.  It  is  mostly  with  ex- 
change value  that  we  are  concerned  here. 

Such  value  is  in  a  sense  determined  by  free  competi- 
tion, by  monoply  conditions,  by  public  authority  and 
by  other  forces.  Under  free  competition  value  is 
largely  fixed  by  supply  and  demand.  Under  this 
system  values  or  prices  tend  to  equal  the  expenses  of 
production  when  these  expenses  or  cost  include  ordinary 
operating  expenses,  depreciation  and  reasonable  returns 
for  interest  and  profits  upon  the  investment.  When 
in  any  line  of  business  prices  yield  more  than  the  cost 
thus  outlined,  additional  competitors  enter  the  field, 
the  effect  of  which  is  to  increase  the  supply  and  con- 
sequently to  decrease  the  price.  When  prices  fall 
below  the  cost  of  production,  existing  competitors  tend 
to  withdraw  from  the  field  until  the  supply  is  reduced 
and  the  prices  raised.  It  is  through  the  operation  of 
these  forces  that  value  or  price  tends  to  equal  the  cost 
of  expense  of  production.  Value  fixed  in  this  way  is 
usually  regarded  as  the  normal  value.  It  is  assumed 
to  be  a  value  that  is  equitable  and  fair  to  all  concerned. 

Under  monopoly  conditions  prices  are  usually  fixed 
at  the  level  where  they  yield  the  greatest  net  returns. 
This  level  is  as  a  rule  higher  than  the  level  of  prices 
under  free  competition.  The  main  reason  for  this 
difference  is  that  under  monopoly  conditions  the  pro- 
ducers have  so  much  better  control  over  the  supply 
that  they  are  able  to  exact  higher  prices.  Prices  fixed 
under  such  conditions  may  therefore  be  contrary  to 
public  interest. 

Public  authorities,  in  fixing  values  and  prices,  are 


DEPRECIATION 


113 


supposed  to  be  governed  by  principles  of  equity  and 
justice.  To  that  end  theyj^^mostly  rely  for  guidance 
upon  conditions  which  obtain  under  free  competition. 
Normal  values  or  prices  such  as  are  fixed  by  free  com- 
petitive forces  and  which  tend  to  equal  the  cost  of 
production  are,  therefore,  largely  adopted  by  public 
authorities  as  the  basis  for  the  value  or  price  which 
they  fix.  As  such  values  are  generally  recognized  as 
fair,  no  better  standards  could  probably  be  adopted. 
When  the  normal  values  as  fixed  by  competition  are 
applied  as  bases  for  fixing  values  of  public  utilities  and 
other  enterprises  where  monopoly  conditions  obtain, 
the  relations  upon  which  values  depend  are  to  a  con- 
siderable extent  altered.  Under  competitive  conditions 
the  value  of  capital,  or  production  goods,  is  largely 
determined  by  what  is  regarded  as  the  normal  earnings. 
In  the  public  utility  or  monopoly  field,  when  values  are 
based  on  competitive  results,  it  is  the  normal  value 
thus  fixed  that  largely  determines  the  amount  to  be 
earned.  In  the  competitive  field,  value  usually  de- 
!  pends  on  normal  earnings;  in  the  regulated  monopoly 
[  field  earnings  mostly  depend  on  normal  value. 
,  By  the  term  cost  of  production  as  a  price  regulator 
in  the  competitive  field  is  frequently  meant  the  cost 
of  reproduction.  This  is  especially  true  when  con- 
siderable changes  have  taken  place  in  the  cost  of  pro- 
duction between  the  time  the  commodities  were  actually 
produced  and  the  time  they  are  sold.  This  is  of  the 
greatest  importance.  In  all  probability  it  is  responsible 
for  the  fact  that  courts  and  other  public  authorities 
in  determining  the  fair  value  of  public  utilities  are 
guided  by  both  the  original  cost  and  the  cost  of  repro- 
duction of  the  property  and  business.  Reliable  facts 
bearing  upon  these  two  costs  are  therefore  necessary 
in  the  work  of  determining  the  fair  value  of  the  prop- 
erty of  public  utilities. 

By  original  cost  in  this  connection  it  seems  to  me 
should  be  understood  the  cost  at  which  the  existing 
property  used  by  public  utilities  in  rendering  service 
was  acquired.  By  cost  of  reproduction  is  meant  the 
cost  of  reproducing  the  existing  property  under  pre- 
vailing conditions.  The  original  cost  of  the  existing 
property  should  be  shown  by  the  books  and  records 
of  the  utilities  provided  these  have  been  properly  kept 
and  are  still  in  existence.  When  the  books  have  not 
been  so  kept  or  are  not  available,  the  original  cost  as 
thus  outlined  may  be  determined  very  much  in  the 
same  manner  as  that  in  which  the  cost  of  reproduction 
is  found. 

In  order  to  determine  the  cost  of  reproduction  it  is 
necessary  to  have  complete  inventories  of  all  the 
material,  labor  and  services  that  have  entered  into  the 
plant.  To  this  end  it  is  further  necessary  to  have  com- 
plete price  lists  of  such  material,  labor  and  services 


covering  not  only  existing  prices,  but  the  prices  that 
have  prevailed  for  some  years  in  the  past.  In  the  case 
of  prices  which  fluctuate  sharply,  it  may  also  be  neces- 
sary to  weight  these  prices.  Consideration  should 
further  be  given  to  the  general  trend  in  the  course  of 
the  prices.  To  do  so  is  important,  since  most  valua- 
tions are  made  for  the  future  as  well  as  for  the  present. 
When  the  original  cost  of  the  existing  property  is 
desired  it  can  be  computed  upon  the  same  inventory 
as  that  used  in  determining  the  cost  of  reproduction 
and  upon  prices  which  cover  the '  period  when  the 
property  involved  was  put  into  the  plant.  Such  price 
lists  may  be  had  partly  from  the  records  of  the  plant 
and  partly  from  other  sources.  In  this  way  the 
original  cost  of  the  existing  property  can  be  had  with 
even  greater  accuracy  than  the  cost  of  reproduction. 

NATURE  OF  DEPRECIATION 

In  the  appraisal  of  pubUc  utiUties,  it  is  usually 
necessary  and  customary  to  determine  the  count  of 
the  depreciation  that  has  accrued  in  the  depreciable 
property.  When  such  accrued  depreciation  is  deducted 
from  the  original  cost  and  the  cost  of  reproduction  of 
the  property,  facts  are  obtained  upon  which  it  is  possi- 
ble to  determine  the  so-called  existing  value  of  the 
property  in  use.  In  addition  to  this,  the  rate  at  which 
the  property  is  depreciating  is  also  a  fact  upon  which 
information  is  much  needed  in  connection  with  the 
question  of  providing  for  accruing  depreciation  in  the 
rates  charged  for  the  service.  To  have  as  much  in- 
formation as  possible  concerning  depreciation  is  there- 
fore of  the  greatest  importance. 

The  greater  proportion  of  the  property  of  public 
utilities  is  constantly  deteriorating  through  use  and 
otherwise,  until  it  becomes  ineflficient  or  useless  and 
must  be  replaced  by  new  property  or  units.  The 
process  of  thus  providing  and  maintaining  the  necessary 
capital  under  the  capitalistic  method  of  production  is 
described  by  R.  T.  Ely  in  his  Outlines  of  Economics 
as  follows: 

"The  stock  of  capital  in  existence  at  any  one  time  is  the 
result  of  savings.  But  this  stock  of  capital  cannot  be  main- 
tained intact  without  more  savings.  From  this  point  of 
view  we  may  say  that  the  sacrifice  of  present  goods  for 
future  goods  which  society  undergoes  in  order  to  reap  the 
advantages  of  capitalistic  production  is  not  something  that 
is  done  once  for  all,  but  is  a  continuous  sacrifice. " 

The  causes  of  such  depreciation  are  usually  grouped 
under  four  heads,  wear  and  tear,  age  or  general  decay, 
inadequacy,  and  obsolescence.  Of  these  wear  and  tear, 
and  age  or  general  decay,  are  of  a  physical  nature, 
while  inadequacy  and  obsolescence  are  of  a  social 
nature.     Such  depreciation  as  that  which  is  due  to 


114 


THE      UTILITIES      MAGAZINE 


changes  in  the  value  of  money  and  to  the  relation  of 
supply  and  demand  and  other  general  causes  of  this 
nature  are  not  included  in  the  depreciation  in  question 
here. 

Under  wear  and  tear  are  usually  classed  the  wearing 
out  and  breaking  of  the  minor  parts  of  larger  units  or 
equipment.  These  parts  must  be  repaired  or  replaced 
in  order  that  the  working  eflBciency  of  the  unit  may  be 
kept  up.  Age,  physical  decay  or  decrepitude  represents 
the  wear  and  tear  or  general  decay  of  the  larger  units 
as  a  whole,  which  decay  cannot  be  made  good  by  minor 
renewals  or  without  replacing  the  unit  itself.  It  is 
largely  due  to  the  action  of  the  elements  upon  physical 
things.  Inadequacy  is  that  reduction  in  value  which 
arises  from  unexpected  developments  and  growth  in 
population  and  business,  public  requirements  and 
other  similar  causes.  Obsolescence  is  depreciation 
due  to  progress  in  the  art  and  to  the  development  of 
more  modern  and  effective  methods. 

In  private  undertakings,  under  free  competition,  the 
prices  in  the  long  run  are  high  enough  to  cover  operating 
expenses,  depreciation  and  sufficient  returns  for  interest 
and  profits  to  obtain  the  necessary  capital  and  enter- 
priser. Whether  under  free  competition,  the  amounts 
thus  obtained  from  the  public  for  depreciation  are  put 
aside  in  a  reserve  until  needed  for  renewals  or  paid  over 
to  the  stockholders  or  owners,  makes  but  little  difference 
since  the  renewals  must  be  made  when  needed,  if  the 
plant  is  not  going  to  be  crowded  out  of  business.  Under 
free  competition  producers  are  forced  as  a  matter  of 
self-preservation  to  maintain  their  plants  at  the  req- 
uisite standards  of  efficiency. 

In  public  utilities  where  active  competition  is  largely 
absent,  less  can  as  a  rule  be  safely  left  to  the  judgment 
of  the  investors  or  operators.  In  this  field  it  has 
therefore  become  necessary  to  require  by  law  that 
which  is  not  brought  about  through  competition.  In 
order  to  keep  up  the  service  and  maintain  the  invest- 
ment, public  utilities  are  mostly  authorized  by  law  to 
include  the  depreciation  in  the  charges  which  they 
make  for  the  services  they  render  and  are  also  required 
to  place  the  amount  so  collected  for  depreciation  in  a 
reserve  until  needed  for  renewals.  In  this  way  the 
interests  of  both  the  customers  of  the  utility  and  the 
investors  therein  are  best  safeguarded.  To  charge 
depreciation  to  the  public  is  necessary  in  order  to  obtain 
the  capital  needed.  Investors  will  not  in  the  long 
run  furnish  capital  unless  it  is  maintained  and  unless 
they  receive  the  ordinary  returns  thereon.  This  is  as 
true  in  the  public  utility  field  as  in  competitive  indus- 
tries. To  charge  depreciation  to  the  customers  is  also 
just  from  an  equitable  point  of  view  because  deprecia- 
tion represents  capital  that  is  used  up  in  production 
and  is,  therefore,  a  part  of  those  costs  of  the  products 


that  must  be  covered  by  the  prices  that  are  obtained 
for  them.  No  undertaking,  either  in  the  public  utility 
or  in  the  competitive  field,  can  be  regarded  as  a  success 
or  as  a  more  permanent  institution  unless  its  earnings 
are  high  enough  to  cover  reasonable  amounts  for  the 
operating  expenses  and  the  maintenance  of,  and  returns 
on,  the  capital  involved. 

HOW  DEPRECIATION  IS  DETERMINED 

From  what  has  been  said  it  appears  that  cost  of 
repairing  ordinary  wear  and  tear  as  well  as  the  cost  of 
renewing  such  depreciation  as  is  due  to  age  or  general 
decay,  inadequacy  and  obsolescence  are  just  charges  to 
the  operating  expenses.  When  the  ordinary  repairs 
are  charged  directly  to  the  operating  expenses,  the 
amount  that  it  is  necessary  to  provide  for  depreciation 
during  the  useful  life  of  the  property  is  the  difference 
between  the  cost  of  this  property  and  its  salvage  or 
scrap  value.  The  amount  that  should  thus  be  provided 
annually  for  such  depreciation  depends  upon  the  cost 
of  the  property  and  the  length  of  its  useful  life. 

To  correctly  measure  depreciation  is  difficult.  The 
main  reason  for  this  is  that  the  useful  life  of  the  property 
depends  upon  many  factors,  the  precise  effect  of  which 
cannot  often  be  accurately  estimated  in  advance.  To 
obtain  a  fairly  good  idea  of  the  life  of  the  property, 
however,  is  of  the  greatest  importance.  Upon  it  de- 
pends very  largely  whether  the  provisions  that  are 
made  for  depreciation  will  be  found  to  be  adequate 
when  the  property  must  be  renewed.  In  order  to 
correctly  measure  depreciation  it  is  therefore,  among 
other  things,  necessary  to  know  the  cost  and  salvage 
value  of  the  property,  its  probable  useful  life  until  it 
has  to  be  renewed  because  of  age,  or  general  decay,  and 
whether  this  life  is  likely  to  be  shortened  through  such 
causes  as  inadequacy  and  obsolescence.  The  elements 
that  are  involved  in  determining  the  effect  upon  the 
life  of  the  property  by  each  of  the  three  causes  men- 
tioned are  too  numerous  to  be  explained  in  detail  here. 

The  cost  of  the  property  thus  involved  can  usually 
be  had  from  the  records  of  the  plant  or  from  other 
sources.  For  reliable  information  as  to  the  probable 
useful  life  of  such  property,  however,  the  appraisers 
must  usually  rely  on  both  general  and  special  informa- 
tion obtained  from  others  as  well  as  from  their  own 
knowledge  and  experience  in  such  matters.  Much 
general  information  as  to  the  life  of  such  property  is 
usually  found  in  life  tables  compiled  under  varying 
conditions.  Such  tables  are  useful,  but  may  not  take 
full  account  of  conditions  that  are  peculiar  to  the 
plant  under  review.  Special  conditions  of  this  kind 
can  only  be  discovered  and  measured  by  personal  ex- 
aminations by  competent  appraisers.  It  is  under 
such  conditions  that  personal  experience  and  careful 


DEPRECIATION 


115 


inspection  become  of  the  greatest  importance.  Ex- 
perience, however,  indicates  quite  clearly  that  the  best 
results  are  obtained  when  both  life  tables  and  the 
personal  inspection  method  are  employed  in  estimating 
depreciation.  This  is  true,  regardless  of  whether  the 
information  desired  relates  to  past  depreciation  of 
existing  property  or  to  the  probable  future  rate  of 
depreciation  of  the  plant.  In  order  to  obtain  full 
light  upon  the  situation  it  is  usually  necessary  to  know 
the  cost  and  life  of  each  unit  of  property  as  well  as  of 
the  plant  as  a  whole. 

HOW  DEPRECIATION  SHOULD  BE  PROVIDED 

FOR 

It  has  thus  been  pointed  out  that  from  a  legal,  as 
well  as  from  an  economic  point  of  view,  depreciation 
as  defined  above  is  properly  chargeable  to  the  operating 
expenses  of  a  plant  or  to  the  cost  upon  which  its  rates 
for  service  are  based.  It  has  also  been  shown  that 
such  depreciation  amounts  to  the  difference  between 
the  cost  of  the  property  and  its  salvage  value  and  that 
the  annual  charge  depends  on  the  cost  and  life  of  the 
property.  It  has  been  said  further  that,  while  depre- 
ciation is  not  easily  determined,  a  fairly  good  measure- 
ment of  it  may  be  had  from  past  experience  formulated 
into  life  tables  and  from  personal  observation  under 
close  inspection  of  the  property.  The  question  now 
is  how  can  depreciation  be  best  and  most  economically 
provided  for  in  the  charges  which  are  made  for  it  in  the 
rates  for  the  services  rendered. 

The  fact  that  depreciation,  the  same  as  ordinary 
repairs,  is  a  proper  charge  to  the  operating  expenses  has 
not  always  been  generally  recognized.  This  failure 
to  recognize  the  true  nature  of  depreciation  has  often 
been  more  or  less  responsible  for  practices  that,  from 
an  economic  point  of  view  at  least,  may  be  looked  upon 
as  rather  questionable.  Thus  the  cost  of  renewals  has 
often  been  charged  to  construction  and  paid  for  by  the 
proceeds  from  additional  security  issues.  It  has  prob- 
ably also  caused  many  investors  to  think  that  the 
profits  in  the  public  utility  and  other  fields  were  greater 
than  is  actually  the  case  and  to  make  investments 
therein  on  terms  which  they  otherwise  would  not  have 
accepted.  To  charge  renewals  to  capital  instead  of  to 
the  operating  expenses  is  out  of  line  with  public  policy. 
This  becomes  clear  when  the  facts  involved  are  viewed 
in  the  light  of  recognized  economic  theories.  Only  in 
exceptional  cases,  such  as  the  destruction  of  property 
through  undeserved  calamities  and  accidents,  and 
under  highly  abnormal  conditions  in  other  respects, 
would  it  seem  to  be  just  to  charge  renewal  to  the  capital 
accounts,  and  even  in  such  cases  such  charges  should, 
as  a  rule,  only  be  for  limited  periods. 

Ordinary  repair  charges  are  fairly  regular.     These 


charges  can  therefore  go  directly  to  operating  expenses 
without  causing  undue  fluctuations  therein.  With 
depreciation  proper  the  situation  in  this  respect  is 
different.  Such  depreciation  is  constantly  going  on 
and  on.  The  whole  is  about  the  same  one  year  as  the 
other.  The  actual  outlays  for  renewals,  however,  are 
irregular  and  for  most  plants  are  much  greater  during 
some  years  than  during  other  years.  These  outlays 
are  in  fact  of  such  nature  that,  in  most  cases,  they 
cannot  be  equally  distributed  from  year  to  year.  In 
order  to  prevent  serious  fluctuations  in  the  operating 
expenses  and  in  the  net  earnings,  and  in  order  also  to 
keep  the  investment  intact,  it  is,  as  a  rule,  best  to  pro- 
vide for  such  renewals  in  advance  through  regular  an- 
nual charges  to  the  operating  expenses,  which  charges 
are  adjusted  as  closely  as  possible  to  the  time  during 
which  depreciation  is  accrued  and  which  charges,  when 
collected  from  the  customers,  are  set  aside  as  a  reserve 
until  needed  for  renewals.  The  larger  plants  or  com- 
binations of  plants  including  railways,  however,  are 
often  able  to  so  adjust  their  renewals  that  the  charges 
for  the  same  remain  somewhat  more  constant  from  year 
to  year.  When  this  is  the  case  it  is  not  always  necessary 
to  provide  for  depreciation  in  advance  in  order  to 
equalize  the  charges  to  the  operating  expenses  or  to 
keep  up  the  service. 

In  such  cases  the  cost  of  the  renewals  when  incurred, 
like  repairs,  can  often  be  charged  directly  to  the  operat- 
ing expenses.  The  cost  of  current  renewals  alone, 
however,  does  not  cover  all  the  depreciation  that  has 
accrued  in  a  plant.  Owing  to  the  fact  that  much  of 
the  property  at  any  given  period  necessarily  has  been 
in  use  for  some  time,  the  service  value  is  always  less 
than  the  cost.  Unless  this  difference  has  been  made 
good  by  charges  to  the  customers,  the  investment  has 
not  been  kept  intact.  As  long  as  the  standard  of 
upkeep  is  high  and  the  service  is  adequate,  and  as  long 
as  they  are  not  required  to  bear  depreciation  that  should 
have  been  borne  by  previous  users,  the  customers  of 
the  plant  would  probably  not  object  to  this  practice. 
To  them  it  would  then  simply  mean  that  they  might, 
for  a  time  at  least,  be  relieved  from  making  good  a  part 
of  the  capital  that  had  been  used  up  in  serving  them. 
For  the  investor,  however,  the  situation  would  be  differ- 
ent. His  investment  through  this  practice  would  not 
be  kept  intact.  The  extent  to  which  it  would  fall  short 
of  this  would  be  measured  by  the  amount  of  the  accrued 
depreciation  of  his  property  and  the  amount  to  cover 
such  depreciation  that  had  been  collected  from  the 
customers.  Should  this  difference  between  the  accrued 
depreciations  and  the  provisions  for  covering  it  ever 
have  to  be  made  up,  it  is  also  likely  that  under  this  prac- 
tice, owing  to  the  fact  that  customers  are  constantly 


116 


THE      UTILITIES      MAGAZINE 


changing,  it  would  have  to  be  borne  by  others  than 
those  for  whose  benefit  the  capital  was  used  up. 

In  view  of  all  this  it  would  seem  that  for  public 
utUities  which  are  institutions  of  a  pubhc  nature  and 
for  which  both  the  customers  and  the  investors  are 
constantly  changing,  the  best  and  most  equitable 
practice  is  to  cover,  about  as  it  is  accrued,  the  entire 
estimated  annual  depreciation  in  the  charges  that  are 
made  for  the  services  they  render  and  to  set  aside  in  a 
reserve  the  amounts  so  collected  to  be  held  therein  until 
needed  for  renewals.  This  practice  offers  many  ad- 
vantages. Under  it  depreciation  wiU  be  provided  for 
during  the  period  when  it  is  accrued,  and  these  provi- 
sions will,  therefore,  have  to  be  borne  by  those  who 
received  the  service  and  who  should  bear  it.  Under 
it,  further,  the  investment  will  be  kept  intact,  or  approx- 
imately so,  and  the  service  adequate. 

When  depreciation  is  thus  provided  for  by  being 
collected  from  the  customers  on  about  the  same  basis  or 
during  the  same  period  as  that  during  which  it  is  accrued, 
it  is  usually  computed  on  either  the  so-called  straight  line 
or  on  the  sinking  fund  basis.  Under  the  straight  line 
basis  the  value  or  the  amount  of  the  depreciation  to  be 
covered  is  divided  by  the  useful  life  of  the  unit  or  the 
plant.  The  result  thus  obtained  is  the  amount  that 
should  be  set  aside  annually  for  depreciation.  Thus, 
if  the  cost  of  a  unit  is  $1,000  and  its  life  ten  years,  the 
annual  charge  for  depreciation  will  be  $100. 

Under  the  sinking  fund  basis  it  is  assumed  that  the 
amounts  thus  collected  and  set  aside  for  depreciation 
are  invested  at  compound  interest  imtil  needed  for 
renewals,  and  that  these  amounts  plus  the  interest 
accretions  thereon  will,  at  the  end  of  the  life  of  the  imit, 
equal  its  depreciation.  The  difference  between  the 
sinking  fund  and  the  straight  line  method  is  that  imder 
the  former  method  the  amounts  set  aside  for  deprecia- 
tion are  used  productively  while  in  the  latter  case  they 
are  not  supposed  to  be  so  used.  The  result  of  this 
difference  in  practice  is  that  the  amount  that  has  to  be 
collected  from  the  customers  is  smaller  under  the  sink- 
ing fund  method  than  is  the  case  under  the  straight 
line  method.  The  difference  in  the  amount  thus 
collected  annually  under  the  two  methods  will  depend 
upon  the  rate  of  interest  that  can  be  earned  on  the 
balance  in  the  reserves. 

Much  has  been  said  about  the  relative  merits  of  the 
straight  line  and  sinking  fund  methods  of  providing 
for  depreciation.  Without  going  into  details  in  this 
matter  it  can  be  said  that  the  sinking  fund  method 
implies  a  more  efficient  use  of  the  reserves.  It  also 
means  that,  because  of  such  use,  the  amounts  the  cus- 
tomers will  have  to  contribute  to  cover  depreciation 
is  less  than  under  the  straight  line  method.  The 
inference  that  can  be  drawn  from  these  facts  is  that  the 


sinking  fund  method  is  the  most  economical  and  hence 
would  also  seem  to  be  the  best  of  the  two  methods  from 
the  point  of  view  of  public  interests. 

DEPRECIATION  AND  FAIR  VALUE 

This  brings  us  to  the  question:  How  shall  depre- 
ciation be  treated  in  determining  the  fair  value  of 
public  utilities?  To  correctly  answer  this  question  is 
exceedingly  difficult  and  this  for  the  reason  that  the 
answer  must  be  drawn  from  facts  and  conditions  that 
are  not  only  complicated  but  often  confficting.  It  is 
also  a  question  that  is  not  easily  separated  from  per- 
sonal views  and  interests. 

Dm-ing  the  early  years  in  the  life  of  a  plant  few 
renewals  are  required  and  the  expenditures  for  this 
purpose  are  therefore  small.  As  the  plant  grows  older, 
however,  and  the  different  classes  of  perishable  prop- 
erty of  which  it  is  made  up  are  reaching  the  end  of 
their  useful  life  and  must  be  renewed,  the  renewal 
expenditures  are  gradually  increasing.  After  some 
years  a  condition  is  reached  under  which  the  cost  of 
such  renewals  remains  somewhat  more  constant.  At 
any  rate,  this  is  the  case  when  the  plant  is  properly 
maintained  at  all  times  and  when  the  variations  in  the 
useful  life  of  the  different  classes  of  the  property  is 
not  out  of  the  ordinary.  When  this  state  in  the 
composite  life  of  a  plant  is  reached,  or  when  its  condi- 
tion in  this  respect  may  thus  be  said  to  have  become 
normal,  its  existing  or  service  value,  owing  to  the 
depreciation  that  has  accrued  in  the  property,  is  in  a 
sense  less  that  its  cost  new.  This  would  seem  to  be 
true  even  when  it  renders  as  good  or  better  service 
than  it  ever  did.  Differences  of  this  kind  between 
the  cost- Value-when-new  and  the  cost- value-new-less- 
accrued-depreciation  can  not  be  made  up  by  actual 
renewals  if  each  unit  of  property  is  to  be  kept  in  service 
as  long  as  it  is  efficient  and  if  it  is  to  be  economically 
used  in  other  respects.  This  difference  between  the 
cost  new  and  the  present  value  is  represented  by  the 
depreciation  that  has  accrued  in  its  property,  and  its 
treatment  in  the  valuation  is  the  subject  of  many  con- 
troversies. Some  hold  that  in  appraising  the  plant 
accrued  depreciation  should  be  deducted  from  the  cost 
new;  others  again  contend  that  this  depreciation  should 
not  be  so  deducted. 

In  order  to  throw  some  light  on  these  questions  it 
appears  necessary  to  know  whether  the  plants  are 
operating  under  normal  conditions  and  to  explain 
further  the  relations  which  obtain  between  the  investor 
and  the  customer. 

It  is  only  to  plants  that  are  operating  under  normal 
conditions  that  standard  rules  and  practices  can  be 
fully  applied.  Plants  that  are  operating  under  ab- 
normal conditions  can  not  often  be  judged  in  the  light 


DEPRECIATION 


117 


of  ordinary  standards.  A  plant  so  situated  that  it 
can  not  render  reasonably  adequate  service,  or  which, 
when  it  charges  all  the  service  can  bear,  can  not  earn 
enough  for  what  is  ordinarily  regarded  as  reasonable 
returns,  has  to  be  dealt  with  in  the  light  of  the  peculiar 
conditions  by  which  it  is  surrounded. 

The  relation  between  the  investor  and  customer 
expressed  in  economic  terms  is  that  the  investor  fur- 
nishes a  production  good  for  the  purpose  of  producing 
consumption  goods  or  service  on  the  condition  that  he 
is  paid  interest  on  his  production  good  and  that  the 
production  good  itself  is  either  returned  to  him  unim- 
paired when  no  longer  needed,  or  kept  intact  when 
the  conditions  are  such  that  it  must  permanently  remain 
in  the  business.  In  the  utility  field  this  means  that 
the  investor  supplies  the  capital  and  the  management 
and  undertakes  at  all  times  to  furnish  adequate  serv- 
ice. The  customer,  for  the  service  he  receives,  under- 
takes to  pay  rates  that  are  high  enough  to  cover  reason- 
able allowances  for  the  cost  of  operation,  depreciation 
and  returns  on  the  investment. 

The  value  of  the  investment,  as  has  been  explained, 
is  largely  measured  by  the  original  cost  of  the  property 
involved  and  by  the  cost  of  reproducing  it.  The 
depreciation  of  this  property  is  represented  by  the 
waste  and  destruction  to  which  it  is  subjected  while 
used  in  the  service.  This  waste  is  not  easily  measured 
but  can  usually  be  approximately  determined  from 
experience  and  observation. 

Such  waste  or  depreciation  as  this  must,  as  a  rule, 
be  made  good  by  the  customer.  This  could  hardly 
be  otherwise  since  the  property  is  used  up  in  the  service 
for  the  benefit  of  those  who  are  served,  and  since  the 
necessary  capital  cannot  in  the  long  run  be  had  unless 
such  wastes  are  made  good.  It  is,  in  fact,  as  much  a 
part  of  the  cost  of  the  service  that  has  to  be  borne  by 
the  customers  as  any  other  item  that  should  be  included 
therein. 

In  order  that  such  depreciation  charges  may  be 
equitably  distributed  among  the  customers,  it  is  neces- 
sary that  they  should  be  levied  in  about  equal  annual 
instalments  during  the  period  when  the  property  they 
cover  is  used  up  in  the  service.  If  this  is  not  done 
the  cost  of  depreciation  may  have  to  be  borne  by 
many  who  were  not  using  the  service  when  the  depre- 
ciation was  accrued  and  who,  therefore,  should  prob- 
ably not  be  required  to  bear  it.  Since  utilities  furnish 
continuous  instead  of  temporary  service,  the  amounts 
thus  collected  for  depreciation  can  not,  as  stated,  safely 
be  turned  over  to  the  investors  but  must  be  kept  in 
the  business.  In  other  words,  these  amounts  should 
be  set  aside  in  a  reserve  until  needed  for  renewals. 
In  this  way  both  the  capital  of  the  investor  and  the 
service  of  the  customers  are  best  protected.     Any  other 


course  might  not  only  deprive  the  public,  in  whole  or 
in  part,  of  one  of  its  most  indispensable  necessities, 
but  it  might  result  in  losses  to  the  investors  of  all  or  a 
part  of  their  property.  How  precarious  the  situation 
for  the  investors  may  be  in  such  cases  is  illustrated  by 
the  fact  that  in  condemnation  cases,  and  sometimes 
also  in  rate  cases,  it  is  held  that  the  cost-new-less- 
depreciation  is  the  best  evidence  of  the  value.  That 
adequate  provisions  be  made  for  depreciation  and  that 
the  reserves  accumulated  through  such  provisions  be 
wisely  and  properly  managed,  is,  therefore,  of  the 
greatest  importance  to  both  the  public  and  the  investor. 

When  the  rates  paid  by  the  customer  for  the  service 
cover  all  reasonable  charges  including  depreciation, 
when  the  service  is  adequate  and  when  the  reserves 
for  depreciation  are  properly  kept  and  managed,  the 
reciprocal  obligations  between  the  customers  and  the 
investors  appear  to  have  been  lived  up  to  in  their  most 
important  aspects.  Adequate  service  is  inextricably 
bound  up  with  adequate  provisions  and  properly 
managed  reserves  for  depreciation. 

From  all  this  it  appears  that  the  question  of  how 
depreciation  is  to  be  treated  in  the  valuation  depends 
very  largely  upon  whether  the  depreciation  that  has 
taken  place  in  the  property  has  been  covered  in  the 
charges  for  the  service,  and  upon  whether,  if  so  covered, 
the  amounts  thus  collected  for  depreciation  have  been 
placed  in  a  reserve  until  needed  for  renewals  or  paid 
out  to  the  stockholders  in  the  form  of  dividends  or  in 
some  other  way,  for  their  personal  use  and  benefit. 

This  raises  the  question:  What  constitutes  the 
turning  over  to  the  stockholders  of  the  funds  so  col- 
lected for  depreciation?  Such  funds  are  not  so  turned 
over  when,  after  being  collected  by  the  utility,  they  are 
simply  set  aside  in  a  reserve  and  properly  employed 
until  needed  for  renewals.  It  can  not  mean  this,  for, 
when  so  handled,  the  funds  are  in  the  control  of  the 
utility  rather  than  of  the  investors  therein.  Under 
this  method  the  funds  are  also  used  for  the  benefit  of 
the  customer,  for  they  are  used  for  the  benefit  of  the 
customer  when  expended  for  renewals  that  are  neces- 
sary to  keep  up  the  service,  and  when  the  balance 
above  the  current  expenditures  for  this  purpose,  while 
awaiting  further  renewals,  is  so  used  as  to  earn  interest 
for  the  reserve,  which  interest,  when  so  earned,  is 
applied  in  such  a  way  as  to  reduce  by  that  much  the 
amoun  t  the  customers  have  to  bear  for  depreciat  ion .  As 
long  as  the  funds  are  so  used  the  rights  of  the  investor 
in  the  assets  of  the  plant  have  in  no  way  been  changed. 
The  total  investment  is  about  the  same  as  it  was  before 
any  depreciation  had  set  in  and  before  any  provisions 
had  been  made  for  it.  The  form  of  the  investment, 
however,  has  changed  somewhat.  It  has  been  shifted 
from  the  cost-new  of  the  property  to  its  cost-new-less- 


118 


THE      UTILITIES      MAGAZINE 


depreciation  plus  the  balance  in  the  reserve.  If  this 
balance  equals  the  accrued  but  unmatured  deprecia- 
tion in  the  plant,  the  investment  may  be  said  to  have 
been  kept  intact  in  so  far  as  depreciation  is  concerned. 
Such  handling  of  the  funds  for  accrued  depreciation 
as  that  outlined  in  this  paragraph  is  not  only  sound  from 
a  legal,  but  from  an  economic  standpoint.  It  is  in 
line  with  good  practice. 

In  order  that  funds  collected  for  depreciation  shall 
have  been  turned  over  to  the  stockholders,  it  would 
seem  necessary  that  these  funds  be  released  from 
the  control  of  the  plant  and  actually  paid  over  to  its 
stockholders  for  their  private  use.  When  such  funds 
are  so  turned  over  the  assets  of  the  plant  have  by  that 
much  been  diminished.  The  stockholder's  equity,  then, 
no  longer  consists  of  the  cost  new  less  depreciation 
plus  the  balance  reserved  for  accrued  depreciation, 
but  of  the  cost  new  less  depreciation  only.  If  depre- 
ciation reserves  make  up  a  part  of  the  assets  which 
constitute  the  original  investment  it  would  also  seem 
to  follow  that  the  withdrawal  of  such  reserves  would 
y  be  tantamount  to  the  withdrawal  of  original  assets. 
'  It  is  of  course  true  that  such  demands  for  funds  for 
renewals  may  arise  that  the  reserves  so  withdrawn 
may  have  to  be  paid  back  to  the  plant.  Should  this 
happen,  and  it  frequently  has  happened,  then  it  is,  of 
course,  necessary,  in  the  interest  of  fair  play,  to  take 
the  amounts  so  restored  into  account  in  determining 
whether  the  funds  in  the  reserve  had  been  paid  over 
to  the  stockholders. 

When  no  provisions  whatever  in  the  rates  have  been 
made  for  depreciation,  or  when  only  such  amounts 
for  this  purpose  have  been  included  in  the  expenses 
or  rates  as  have  actually  been  required  for  renewals, 
leaving  accrued  but  unmatured  depreciation  unpro- 
vided for,  no  funds  from  this  source  can  have  been 
available  either  for  credits  to  the  reserve  or  for  pay- 
ment to  the  stockholders. 

It  appears  from  this  that,  in  cases  where  the  utilities 
have  properly  provided  for  depreciation,  and  where 
the  amounts  so  provided  have  been  used  for  necessary 
and  proper  renewals  and  for  the  accumulation  of  a 
reserve  for  the  purpose  of  covering  the  accrued  but 
unmatured  depreciation  of  the  property  still  in  use, 
no  reduction  from  the  cost  new,  because  of  depreciation, 
should  be  made  in  determining  the  fair  value  for  rate 
making  and  certain  other  purposes. 

This  conclusion  would  also  seem  to  apply  in  cases 
where  railroads  and  other  public  utilities  have  fol- 
lowed the  policy  of  including  in  their  operating  ex- 
penses or  costs  upon  which  their  rates  are  based,  only 
such  amounts  for  depreciation  as  were  actually  required 
for  renewals.  Under  this  method  of  dealing  with 
depreciation  no  provisions  can  very  well  have  been 


made  for  accrued  but  unmatured  depreciation.  This 
practice  was  quite  generally  adhered  to  up  to  the  time 
of  the  advent  of  the  present  systems  of  regulation. 
It  has  generally  meant  that  no  provisions  whatever 
have  been  made  for  accrued  but  unmatured  deprecia- 
tion. In  such  cases,  and  they  are  numerous,  there 
has  manifestly  not  been  any  return  of  capital  to  the 
investor  in  the  form  of  depreciation  balances  of  any 
kind.  Not  only  this,  but  the  customers  have  so  far 
also  been  relieved  from  providing  more  than  a  part 
of  the  depreciation  that  has  taken  place  in  the  property. 
While  the  customers,  as  long  as  the  service  is  good, 
and  as  long  as  they  are  not  called  upon  to  make  up 
past-due  depreciation  charges,  may  not  object  to  this 
practice,  the  investor  is  in  an  entirely  different  situa- 
tion. For,  under  this  practice,  the  investor  will  find 
that  a  part  of  his  investment  has  been  used  up  without 
being  replaced  by  assets  of  any  kind.  Under  such  con- 
ditions, it  would  hardly  seem  fair  to  deduct  accrued 
depreciation  from  the  cost  new  in  appraising  the 
property. 

The  situation,  however,  may  be  different  when  the 
reserves  for  accrued  depreciation  which  were  furnished 
or  provided  by  the  customers  have  been  paid  out  to 
the  investors,  and  have  been  appropriated  by  them 
for  their  own  private  use.  In  such  cases  as  this,  a 
situation  is  created  under  which  justice  may  demand 
that  the  accrued  depreciation  is  deducted  from  the 
cost  new  and  that  the  cost  new  less  such  accrued  depre- 
ciation is  used  as  the  controlling  evidence  of  value  in 
the  appraisals.  Unless  such  reserves  so  withdrawn 
are  in  some  way  restored  to  the  business  for  their 
proper  purpose,  it  is  hard  to  find  any  equitable  ground 
for  not  deducting  the  accrued  but  unmatured  depre- 
ciation from  the  cost  new  in  the  appraisals. 

It  is  often  argued  and  with  some  force  that,  as  long 
as  renewals  are  made  when  required,  and  as  long  as 
the  service  is  adequate,  the  cost  new  of  the  property, 
regardless  of  how  depreciation  has  been  treated,  should 
be  the  measure  of  its  value.  These  arguments  have  in 
some  instances  been  presented  in  such  form  that  a  more 
complete  analysis  of  the  same  would  require  much  more 
space  than  could  be  given  to  them  herein.  It  may  be 
said,  however,  that  the  above  position  as  thus  stated 
seems  to  be  too  sweeping  and  to  demand  certain 
modifications.  When  analyzed  in  the  light  of  what  has 
been  said  herein,  for  instance,  it  appears  that  the  cost 
new  can  hardly  be  the  most  equitable  measure  of 
value  in  cases  where  full  depreciation  has  been  covered 
by  the  earnings,  and  where  the  balance  above  the  cost 
of  actual  renewals,  for  the  accrued  but  unmatured 
depreciation  has  been  turned  over  to  the  investors. 

It  may  be  said,  however,  in  this  connection  that 
such  deductions  of  accrued  depreciation  from  the  cost 


DEPRECIATION 


119 


new  in  cases  where  the  reserves  for  such  accrued  depre- 
ciation have  thus  been  paid  out  to  the  stockholders  is 
often  questioned  on  legal  grounds.  It  is  argued,  for 
instance,  that  the  question  of  whether  the  rates  in 
effect  previously  to  the  time  of  the  advent  of  regulation 
were  high  enough  to  cover  depreciation  cannot  be 
legally  inquired  into,  since  at  that  time  there  were  no 
rules  of  law  upon  which  the  reasonableness  of  the  rates 
could  be  determined.  Without  attempting  to  answer 
this  argument  it  may  be  said  that,  if,  as  has  been  held, 
the  statutes  which  provide  for  our  present  form  of 
regulation  are  in  substance  declaratory  of  the  common 
law,  it  would  also  seem-  that  the  obligations  and  rights 
which  constitute  the  real  basis  for  regulation  date 
back  much  farther  than  to  the  present-day-system 
legislation  upon  this  subject.  The  determination  of 
whether  in  the  past  the  rates  have  been  high  enough 
to  cover  depreciation  is  more  likely  to  depend  upon 
whether  the  facts  that  are  necessary  for  such  deter- 
mination can  be  had,  than  upon  whether  such  deter- 
mination is  within  the  law. 

When  the  plants  are  taken  over  by  the  municipality, 
however,  accrued  depreciation  is  usually  deducted 
from  the  cost  new  in  determining  the  purchase  price. 
In  such  cases  the  price  is  supposed  to  cover  only  the 
value  at  the  time  the  property  is  taken  over.  It  is 
further  assumed  that  the  purchaser  becomes  responsi- 
ble for  the  renewals  from  that  time  on.  Whether  to 
so  take  the  property  at  its  present  value  is  fair  to  those 
whose  property  is  thus  taken  over  by  the  municipality 
would  seem  to  depend  upon  whether  the  rates  up  to 
that  time  have  been  high  enough  to  cover  depreciation. 
When  the  rates  have  been  high  enough  for  this  purpose, 
the  assets  of  the  plant  should  equal  its  cost.  When 
the  rates  have  not  covered  depreciation  the  assets  will 
fall  short  of  this  cost.  If,  in  the  latter  case,  the  fair 
price  is  based  upon  the  cost  new  less  accrued  depre- 
ciation, it  must  also  follow  that  the  investors  are  not 
likely  to  be  fully  reimbursed  for  their  outlays  on  the 
plant. 

The  manner,  however,  in  which  the  amounts  pro- 
vided for  depreciation  should  be  treated  until  required 
for  renewals  would  in  a  large  measure  seem  to  depend 
upon  whether  the  plants  are  temporary  or  permanent 
in  their  nature.  When  the  life  of  the  enterprise  is 
short,  or  perhaps  no  longer  than  the  life  of  the  property 
used  in  the  service,  the  amounts  provided  for  depre- 
ciation may  be  regularly  turned  over  to  the  investors. 
Under  this  practice  the  entire  investment  will  neces- 
sarily have  been  so  returned  to  the  investor  when  the 
business  terminates.  In  perpetual  or  more  permanent 
enterprises,  however,  such  as  is  the  case  for  most  public 
utilities,  this  method  of  handling  the  depreciation  re- 
serves is  not  regarded  as  safe.     In  such  enterprises  the 


business  does  not  terminate  with  the  life  of  the  property, 
but  has  to  go  on.  In  order  to  thus  continue  operation, 
it  is  necessary  that  the  property  be  promptly  renewed 
when  worn  out  and  that  for  these  reasons  the  amount 
so  provided  for  depreciation  be  kept  on  hand  by  the 
plants  in  order  that  they  may  be  readily  available  for 
meeting  the  costs  of  such  renewals. 

When  the  amounts  provided  for  depreciation  have 
been  turned  over  to  the  investors,  it  is  obvious  that 
they  cannot  also  be  used  for  the  payment  of  renewals 
unless  they  are  returned  to  the  plant.  Such  returns 
to  the  plant,  however,  of  such  funds  are  apt  to  be 
connected  with  many  uncertainties  and  delays.  These 
uncertainties  and  delays  have  often  been  such  as  to 
make  it  necessary,  in  order  to  protect  the  service,  to 
obtain  funds  for  needed  renewals  from  the  sale  of 
additional  securities  instead  of  from  the  proper  source. 
It  is  because  of  facts  of  this  kind  and  also  because  of 
the  importance  of  maintaining  the  service  that  many 
states  have  deemed  it  necessary  to  require  by  law  that 
the  amounts  provided  for  depreciation  shall  be  held 
by  the  plants  in  a  reserve  until  needed  for  renewals. 

HOW  BALANCE  IN  DEPRECIATION  RESERVE 
MAY  BE  BEST  USED 

The  discussion  up  to  this  point  naturally  suggests 
inquiries  as  to  the  most  economical  use  that  can  be  made 
of  the  balances  held  against  accrued  but  unmatured 
depreciation.  It  was  pointed  out  above  that  all  util- 
ities, if  their  property  is  to  serve  out  its  useful  life  and 
be  used  in  the  most  economical  way,  have  in  this  prop- 
erty a  great  deal  of  accrued  but  unmatured  deprecia- 
tion. If  all  the  property  had  the  same  length  of  useful 
life  and  if  all  of  it  had  been  placed  in  the  service  at 
the  same  time,  then  the  accrued  depreciation  would 
be  small  to  begin  with  and  would  increase  from  year 
to  year  until  the  time  the  property  would  have  to  be 
renewed,  at  which  time  it  would  amount  to  as  much 
as  the  entire  cost  of  all  of  this  property.  In  actual 
practice,  however,  the  situation  is  different.  Owing 
to  the  fact  that  some  classes  of  property  have  a  longer 
useful  life  than  other  classes,  and  owing  to  the  further 
fact  that  the  plants  are,  as  a  rule,  built  from  time  to 
time,  the  renewals,  while  small  at  first,  are  gradually 
growing  greater  until  after  a  few  years,  in  the  larger 
plants  at  least,  they  become  more  evenly  distributed. 
In  the  ordinary  plant,  however,  there  is  never  any 
complete  cycle  in  the  life  of  the  property.  In  the  very 
nature  of  things  there  cannot  be.  Nor  is  a  state  often, 
if  ever,  reached  when,  for  municipal  utilities,  the  annual 
renewals  are  even  nearly  the  same.  When  the  life  of 
the  different  classes  of  property  end  in  different  years, 
however,  it  is  plain  that  the  fluctuations  in  the  renewal 


120 


THE      UTILITIES      MAGAZINE 


requirements  are  smaller  than  they  would  be  if  the 
life  of  all  the  property  terminated  at  the  same  time. 

Owing  to  the  facts  thus  outlined  in  the  preceding 
paragraph  and  when  in  addition  to  this  depreciation 
has  been  correctly  determined  and  fully  provided  for, 
there  is,  as  long  as  conditions  remain  normal,  a  balance 
on  hand  in  the  depreciation  reserve  that  about  equals 
the  accrued  but  unmatured  depreciation  in  the  plant. 
This  is  true  even  though  after  a  few  years  the  outlays 
for  renewals  over  the  diflferent  periods  are  about  as 
great  as  the  receipts  for  depreciation.  While  this 
balance  fluctuates  greatly  even  from  one  year  to  another 
and  while  little  in  the  way  of  more  definite  knowledge 
regarding  this  balance  is  anywhere  to  be  found  in 
print,  it  is  yet  responsible  for  a  great  deal  of  speculation 
as  to  how  it  can  be  best  and  most  justly  employed. 
Some  hold  that  this  balance  belongs  to  the  stockholders 
and  may  be  used  by  them  as  they  see  fit  for  their  own 
benefit.  Others  hold  that  this  balance  should  be  used 
for  the  benefit  of  the  customers.  In  line  with  this, 
it  is  urged  by  many  that  this  balance  should  be  used 
for  the  benefit  of  the  reserve  itself,  in  the  manner  out- 
lined above  in  connection  with  the  explanations  of  the 
sinking  fund  method  of  providing  for  depreciation, 
because  when  it  is  so  used  it  materially  reduces  the 
annual  charges  for  depreciation  that  must  be  borne  by 
the  customers.  Others  again  hold  that  a  better 
practice  would  be  to  devote  this  balance  to  the  reduction 
of  the  value  of  the  investment  and  thereby  lower  the 
amount  upon  which  interest  and  profit  must  be  earned. 
In  other  words,  it  is  thought  that  this  balance  can  be 
safely  turned  over  to  the  investors  as  a  repayment  to 
them  of  an  equal  amount  of  their  capital. 

In  order  to  make  at  least  some  of  these  questions  as 
clear  as  possible  it  has  been  thought  best  to  include  in 
this  part  of  the  discussion  several  illustrations  which 
are  believed  to  be  in  point.  To  this  end  a  hypothetical 
plant  has  been  assumed  with  depreciable  property, 
the  cost  new  of  which  is  placed  at  $1,000,000.  This 
property  has  been  divided  into  eleven  classes,  the  use- 
ful life  of  which  vary  as  between  each  other,  and  range 
from  five  to  fifteen  years.  The  plant  is  also  assumed 
to  have  been  built  in  one  continuous  operation.  The 
annual  requirements  to  cover  the  accruing  depreciation 
of  this  plant  have  been  computed  both  on  a  5  per  cent 
sinking  fund  and  on  the  straight  line  basis.  It  has 
been  assumed  further  that  the  rate  of  depreciation  of 
the  property  has  been  correctly  estimated. 

These  assumptions  for  the  hypothetical  plant  differ 
in  several  respects  from  what,  in  many  cases  at 
least,  is  known  to  be  the  situation  in  actual  practice. 
Most  utility  plants,  for  instance,  have  a  longer  useful 
life  than  that  given  in  the  illustrations  herein.  The 
pate  used  in  the  sinking  fund  computations  herein  is 


also  at  least  1  per  cent  higher  than  the  rate  that  is 
mostly  so  used  in  actual  practice.  Utility  plants  are, 
for  the  most  part,  built  in  piecemeal  rather  than  in  one 
continuous  operation,  as  has  been  assumed  in  these 
illustrations.  Most  plants  also  have  a  great  deal  of 
property,  such  as  land,  which  is  not  subject  to  depre- 
ciation and  which  is  often  worth  a  considerable  amount. 
These  and  other  differences,  however,  that  are  found 
between  the  assumed  plant  herein  and  actual  conditions 
are  not  on  the  whole  of  such  nature  as  to  materially 
affect  the  conclusions  arrived  at. 

The  illustrations  referred  to  are  in  the  form  of  tables. 
Without  going  into  details  it  may  be  said  that  tables  I 
and  II  show,  among  other  things  for  each  class  of  prop- 
erty and  for  the  plant  as  a  whole,  the  expected  life, 
the  total  cost-value,  the  annual  rate  and  the  annual 
amount  that  should  be  provided  for  depreciation  on 
the  sinking  fund  as  well  as  on  the  straight  line  basis. 
Table  m  which  has  been  computed  from  the  facts  in 
Table  II  shows,  for  each  of  the  fifteen  years  covered 
therein,  the  reserve  for  accrued  depreciation  at  the 
beginning  of  the  year,  the  addition  to  this  balance  in 
the  reserve  during  the  year  through  the  regular  annual 
charge  for  the  depreciation,  the  total  of  these  two  items, 
the  annual  requirements  for  renewals,  and  the  balance 
in  the  reserve  at  the  end  of  the  year. 

As  stated  above,  the  property  in  the  hypothetical 
plant  has  been  classified  in  accordance  with  its  useful 
life.  The  shortest  life  of  any  of  these  groups  is  five 
years  while  the  longest  life  is  fifteen  years.  Up  to  the 
fifth  year  no  renewals  were  required.  From  this  time 
on,  the  property  in  one  or  more  of  the  groups  had  to 
be  renewed  each  year.  During  the  fifth  year,  for 
instance,  the  property  in  the  five-year  life  group  had 
to  be  renewed.  At  the  close  of  the  sixth  year  group 
B  had  also  been  renewed.  During  the  seventh  year 
group  C  was  renewed;  during  the  eighth  year  group  D 
was  renewed;  during  the  ninth  year  group  E  was  renew- 
ed; during  the  tenth  year  groups  A  and  F  were  renewed; 
during  the  eleventh  year  group  G  was  renewed;  during 
the  twelfth  year  groups  B  and  G  were  renewed;  during 
the  thirteenth  year  group  I  was  renewed;  during  the 
fourteenth  year  groups  C  and  J  were  renewed;  during 
the  fifteenth  year  groups  A  and  K  were  renewed.  Two 
of  the  groups,  the  first  and  the  eleventh,  had  thus  been 
renewed  during  the  fifteenth  year,  and  in  these  there 
was  therefore  at  the  end  of  this  year  no  accrued  depre- 
ciation. The  remaining  groups,  however,  were  in  a 
more  or  less  depreciated  condition,  the  eighth  group 
so  much  so  that  it  would  have  to  be  renewed  within  a 
year.  It  is  in  this  way  that  it  is  found  that  plants  of 
this  kind  at  all  times  have  in  them  a  great  deal  of  ac- 
crued but  unmatured  depreciation.  At  the  end  of  the 
fifteenth  year  the  plant  had  also  been  in  the  service 


DEPRECIATION 


121 


TABLE  I 
HYPOTHETICAL  PLANT— COST  NEW  $1,000,000. 
METHOD— (5  PER  CENT) 


SINKING  FUND 


Annual  Peb  CHtrr 

Class 

Life 

Weasing  Value 

Reserved  on 
5  Per  Cent  Basis 

Annual  Fund 

A 

5 

10,000 

18.10 

1,810 

B 

6 

25,000 

14.70 

3,675 

C 

7 

50,000 

12.28 

6,141 

D 

8 

50,000 

10.47 

5,236 

E 

9 

100,000 

9.07 

9,069 

F 

10 

50,000 

7.95 

3,975 

G 

11 

65,000 

7.04 

4,575 

H 

12 

100,000 

6.28 

6,293 

I 

13 

50,000 

5.65 

2,823 

J 

14 

100,000 

5.10 

5,102 

K 

15 

400,000 

4.63 

18,537 

1,000,000 

67,226 

67,226 
Average  Rate  i  nnn  ono  —^"^^^  P^""  cent. 

Average  Life  =  11.4  years. 


TABLE  II 
HYPOTHETICAL  PLANT— COST  NEW  $1,000,000. 
LINE  METHOD 


STRAIGHT 


Annual 

Annual  Amt. 

Class 

Life 

Wearing  Value 

Per  Cent  of 
Depreciation 

Required  to  Cover 
Depreciation 

A 

5 

10,000 

20.0 

2,000 

B 

6 

25,000 

16.7 

4.175 

C 

7 

50.000 

14.3 

7,150 

D 

8 

50,000 

12.5 

6,250 

E 

9 

100,000 

11.1 

11,100 

F 

10 

50,000 

10.0 

5,000 

G 

11 

65,000 

9.1 

5,915 

H 

12 

100,000 

8.3 

8,300 

I 

13 

50,000 

7.7 

3,850 

J 

14 

100,000 

7.1 

7,100 

K 

15 

400,000 

6.7 

26,800 

1,000,000 

87,640 

87,640 
Average  Rate  .  „„„  „„„  =  8.764  per  cent. 

Composite  Life  $l,000,000-r$87,640  =  11.42  years. 


TABLE  III 


Yeah 

Reserve  at 

Beginning 

of  Year 

Current 
Depreciation 

Total 

Renewal 
Requirement 

Reserve 

AT  End  of 

Year 

1st 

$87,640 

$87,640 

$87,640 

2d 

$87,040 

87,640 

175,280 

175,280 

3d 

175,280 

87,640 

262,920 

262,920 

4th 

262,920 

87,640 

350,560 

350.5C0 

5th 

350,560 

87,640 

438,200 

10,000 

428,200 

6th 

428,200 

87,640 

525,840 

25,000 

490,840 

7th 

490,840 

87,640 

578,480 

50,000 

528,480 

8th 

528,480 

87,640 

616,120 

50,000 

566,120 

9th 

560,120 

87,640 

653,760 

100,000 

553,760 

10th 

553,760 

87,640 

641,400 

60,000 

581,400 

11th 

581,400 

87,640 

669,040 

65,000 

604,040 

12th 

604,040 

87,640 

691,160 

125,000 

566,680 

13th 

566,680 

87,640 

654,320 

50,000 

604,320 

14th 

604,320 

87,640 

691,960 

150,000 

541,960 

15th 

541,960 

87,640 

629,600 

410,000 

219,600 

long  enough  to  have  reached  a  state  with  respect  to 
the  renewals  that  may  be  regarded  as  normal.  In  other 
words,  the  conditions  with  respect  to  renewals  that 
have  obtained  during  the  latter  half  of  the  fifteen-year 
period  may  also  be  expected  to  prevail  for  much  of  the 
time  in  the  future. 

In  studying  tables  I  and  II  many  important  facts 
may  be  noticed.  The  first  of  these  to  attract  attention 
is  the  amounts  that  are  annually  required  to  cover  the 
depreciation  in  the  property.  This  amount  is  seen  to 
be  $67,226  under  the  sinking  fund  and  $87,640  under 
the  straight  line  method.  The  next  thing  to  be  noticed 
is  the  rate  of  this  depreciation  when  thus  computed 
upon  the  depreciable  property  alone,  instead  of  upon 
the  entire  value  of  the  plant.  This  rate  amounts  to 
about  6.72  per  cent  under  the  former  and  to  about  8.76 
per  cent  under  the  straight  line  method.  Both  the 
amount  of  depreciation  and  the  rate  of  the  same  are 
relatively  higher  than  the  amount  and  rate  that  would 
have  obtained  had  the  plant  been  given  a  longer  life. 
The  life  of  the  hypothetical  plant  herein  has,  for  con- 
venience in  the  computations,  been  given  a  compara- 
tively short  life.  Its  composite  life,  for  instance,  is 
only  about  11.42  years. 

Table  III  is  even  more  important  for  the  purposes 
herein  than  the  two  tables  which  have  thus  been  touched 
upon.  One  reason  for  this  is  that  it  shows  by  years 
not  only  the  amounts  that  were  added  to  the  reserve, 
but  the  withdrawals  therefrom  for  renewals  and  the 
balance  in  the  reserve  at  the  end  of  the  year. 
The  accretions  to  the  reserve  were  uniform.  They 
amounted  to  as  much  one  year  as  the  other.  The 
withdrawals  from  it  for  renewals,  however,  varied 
greatly  from  year  to  year.  During  the  first  four  years 
no  expenditures  whatever  were  required  for  renewals. 
During  the  fifth  year,  however,  they  amounted  to 
$10,000.  From  this  year  on  there  was  a  gradual  in- 
crease in  these  outlays  until  the  end  of  the  ninth  year, 
when  they  suddenly  climbed  up  to  $100,000.  Having 
reached  this  point,  however,  the  upward  tendency  was 
reversed  until  the  twelfth  year,  when  they  amounted 
to  $125,000,  and  the  fourteenth  and  fifteenth  years, 
when  they  stood  at  $150,000  and  $410,000,  respectively. 
While  these  fluctuations  in  the  renewal  curve  would 
have  been  leveled  out  to  some  extent  had  the  plant 
grown  up  through  gradual  extensions  during  a  longer 
period,  they  would  by  no  means  have  been  wiped  out. 
To  entirely  eliminate  such  fluctuations  seems  to  be 
out  of  the  question  except  perhaps  in  very  large  plants, 
and  even  in  these  the  best  efforts  in  this  direction  are 
not  always  successful.  These  facts  emphasize  the 
necessity  for  most  utilities  to  provide  for  depreciation 
about  as  it  is  accrued  rather  than  as  renewals  are  made. 


122 


THE      UTILITIES      MAGAZINE 


in  order  to  avoid  serious  changes  in  their  expenses  and 
net  earnings. 

As  the  cost  of  the  renewals  fluctuated  greatly,  it  is  only 
to  be  expected  that  this  should  also  be  true  of  the  bal- 
ances in  the  reserve  at  the  end  of  each  year.  During 
the  first  four  years,  nothing  was  withdrawn  from  the 
reserve  and  the  balance  therefore  increased  from  $87,600 
at  the  end  of  the  first  year  to  $350,560  at  the  end  of 
the  fourth  year.  Up  to  the  end  of  the  eighth  year,  the 
accretions  to  the  reserve  exceeded  the  charges  to  it, 
and  at  this  time  the  balance  stood  at  about  $566,120. 
From  this  time  on,  up  to  the  end  of  the  fourteenth 
year,  the  balance  therein  did  not  vary  very  much  from 
the  figure  just  given.  During  the  fifteenth  year, 
however,  owing  to  the  heavy  renewals  which  then  had 
to  be  met,  the  balance  fell  to  $219,600.  The  reserves, 
as  shown  in  the  table,  when  taken  as  a  whole,  thus 
exceeded  the  renewals  by  considerable  amounts.  This 
is  very  largely  due  to  the  fact  that  no  renewals  were 
required  during  the  first  four  years  and  to  the  further 
fact  that  they  were  below  the  normal  up  to  about  the 
ninth  year.  During  the  latter  half  of  the  period,  how- 
ever, the  withdrawals  from  the  reserve  for  renewals 
amounted  to  nearly  one  and  one-half  times  as  much 
as  the  accretions  or  credits  to  it.  If  the  computations 
in  Table  III  are  continued  for  another  period  of  fifteen 
years,  it  will  be  found  that,  during  this  period,  the 
aggregate  receipts  in  the  reserve  will  amount  to  only 
about  $19,000  more  than  the  aggregate  disbursements 
therefrom  for  renewals,  and  that  the  balance  in  the 
reserve  at  the  end  of  the  thirtieth  year  will  therefore 
be  little  or  no  greater  than  the  balance  at  the  end  of  the 
fifteenth  year. 

The  question  might  here  be  raised  whether  the 
amount  which  in  the  table  is  annually  allowed  for 
depreciation  is  sufiicient  to  cover  current  renewals  in 
addition  to  the  accrued  but  unmatured  depreciation  in 
the  property.  The  answer  to  this  must  very  largely 
depend  upon  whether  the  life  of  the  property  on  which 
this  allowance  is  based  was  correctly  determined. 
Owing  to  the  difficulties  involved  in  determining  the 
useful  life  of  the  property,  it  is  hardly  to  be  expected 
that  this  relation  between  accrued  depreciation  and 
the  reserve  should  be  exact.  This,  however,  does  not 
invalidate  this  method  of  handling  depreciation. 
Inequalities  of  this  kind  are  of  such  a  nature  that  they 
will  sooner  or  later  come  to  the  surface.  When  they 
thus  appear,  they  can  unquestionably  be  adjusted 
through  necessary  changes  in  the  rates  at  which  the 
reserve  is  accumulated.  It  is  no  more  difficult  to 
adjust  inequalities  of  this  kind  than  it  is  to  adjust 
those  inequalities  which  occur  when  worn-out  units  are 
replaced  by  units  of  either  a  higher  or  a  lower  price, 


and  the  necessities  for  such  and  other  similar  adjust- 
ments are  frequent. 

In  view  of  the  facts  that  have  thus  been  presented, 
it  may  at  this  point  be  asked  whether  any  part  or  all 
of  the  balance  in  the  depreciation  reserve  could  with 
safety  have  been  paid  over  to  the  investors  as  a  return 
of  that  much  of  their  investment.  If  conditions  re- 
mained about  normal,  and  if  all  the  estimates  upon 
which  the  balances  rest  are  about  correct,  then  it 
would  seem  that  at  least  a  part  of  this  balance  could 
have  been  so  used  without  greatly  endangering  the 
service.  Just  what  proportion  of  the  balance  could  be 
safely  devoted  to  this  purpose  is  not  so  clear.  To  so 
pay  over  the  entire  amount  reserved  during  the  first 
four  years  during  which  no  renewals  were  made  would 
hardly  seem  safe,  for  had  this  been  done  there  would 
have  been  no  funds  on  hand  with  which  to  meet  the 
renewals  that  had  to  be  made  during  the  fifth  year. 
Nor  would  it  have  been  good  practice  to  devote  the 
average  yearly  balance  for  the  period  to  this  purpose, 
since  this  balance  considerably  exceeds  the  actual  bal- 
ance for  some  of  the  years.  Taking  everything  Into  con- 
sideration, it  is  probable  that  it  would  not  have  been 
wise  to  use  a  greater  sum  for  such  amortization  than 
the  balance  on  hand  at  the  end  of  the  fifteenth  year, 
which  balance  amounted  to  $219,600.  Had  this 
amount  been  so  used,  the  result  would  have  been  that 
the  entire  balance  in  the  reserve  would  have  been 
wiped  out  and  that  the  investment  in  the  property 
would  have  been  reduced  from  $1,000,000  to  $780,400. 
If  the  plant  had  been  a  growing,  instead  of  a  static 
plant,  it  is  likely  that  the  relation  of  these  figures  to 
each  other  would  have  been  slightly  changed,  but  it  is 
not  probable  that  these  changes  would  have  been  of 
such  character  as  to  permit  a  greater  amount  than  the 
one  named  to  be  used  in  thus  reducing  a  part  of  the 
investment. 

While  it  thus  appears  that  under  normal  conditions 
it  may  be  safe  to  devote  at  least  a  part  of  the  funds  col- 
lected and  reserved  for  depreciation  to  the  amortization 
of  the  capital,  it  is  not  certain  that  it  would  be  to  the 
best  interests  of  either  the  investors  or  the  customers 
to  follow  this  course.  It  is  especially  doubtful  whether 
the  customers  would  gain  anything  thereby.  The 
main  reason  for  this  is  that  if  the  balances  in  the  re- 
serves are  used  for  the  purposes  of  reducing  the  capital, 
it  will  be  necessary  to  collect  or  provide  for  depreciation 
on  the  straight  line,  instead  of  on  the  sinking  fund 
basis,  which  in  turn  would  result  in  increasing  the 
charges  to  the  customers.  In  other  words  what  the 
customers  would  gain  through  lower  interest  charges 
would  be  offset  in  losses  through  higher  charges  for 
depreciation.  That,  in  so  far  as  the  customers  are 
concerned,  the  sinking  fund  method  of  providing  for 


DEPRECIATION 


123 


TABLE  IV 


Method  I 

Method  II 

I 

II 

III 

IV 

V 

VI 

VII 

VIII 

IX 

X 

Savinga  In  Ann. 

Year 

Fair  Value 

Return  @  8 
per  cent 

Annual  Allowance 
for  Deprec. 

Tot.  Return  and 
Deprec.  Method  I 

Fair  Value 

Return  @  8 
per  cent 

Annual  Allowance 
for  Deprec. 

Tot.  Return  and 
Deprec.  per 
Method  II 

Chge.  for  Return 
on  Cap.  and  for 

Maint.  of 

Capital  by  M.  I. 

as  against  II 

1st 

1,000,000 

80,000 

67,226 

147,226 

1,000,000 

80,000 

87,640 

167,640 

20,414 

2d 

1,000,000 

80,000 

67,226 

147,226 

912,360 

72,989 

87,640 

160,629 

13,403 

3d 

1,000.000 

80,000 

67,226 

147,226 

824,720 

65,978 

87,640 

153,618 

6,392 

4th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

5th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

6th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

7th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

8th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

9th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

10th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

11th 

1,000,000 

80,000 

67,226 

147,226 

780.400 

62,432 

87,640 

150,072 

2,846 

12th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

160,072 

2,846 

13th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

150,072 

2,846 

14th 

1,000,000 

80,000 

67,226 

147.226 

780,400 

62,432 

87,640 

150,072 

2,846 

15th 

1,000,000 

80,000 

67,226 

147,226 

780,400 

62,432 

87,640 

160,072 

2,846 

Total 

15,000,000 

1,200.000 

1,008,390 

2,208,390 

12,101,880 

968.161 

1,314,600 

2,282,751 

74,361 

depreciation  is  more  economical,  or  results  in  lower 
charges,  than  the  straight  line  method  has  been  pointed 
out  already.  That  this  should  be  the  case  would  also 
seem  obvious,  since  under  the  sinking  fund  method  the 
balances  in  the  reserve  are  supposed  to  be  so  used  as 
to  bring  in  something  in  the  way  of  returns,  which 
returns,  since  they  also  go  into  the  reserve,  reduce  by 
that  much  the  amount  that  has  to  be  borne  by  the 
customers.  Under  the  straight  line  method,  no  accre- 
tions to  the  reserve  can  be  had  from  this  source.  The 
result  of  this  is  to  increase  by  that  much  the  amounts 
which  the  customers  will  have  to  bear  for  depreciation. 

In  order  to  throw  further  light  on  whether  the  balances 
in  the  reserve  account  should  be  used  productively  for 
the  benefit  of  this  account,  or  whether  these  balances 
should  be  used  for  the  purpose  of  reducing  the  invest- 
ment, Table  IV  has  been  constructed.  In  this  table, 
under  method  I,  is  shown  the  total  cost  to  the  customers 
of  both  the  returns  on  the  investment  and  the  charges 
for  depreciation  when  the  latter  are  computed  on  the 
sinking  fund  basis.  Under  method  II  in  this  table  is 
shown  the  total  cost  to  the  customers  of  both  the 
returns  on  the  investment  when  the  Investment  is 
gradually  reduced  by  $219,600,  which  sum  it  was 
thought  safe  to  take  out  of  the  reserve  for  this  purpose, 
and  of  the  charges  for  depreciation  when  these  charges 
are  computed  on  the  straight  line  basis.  The  invest- 
ment and  depreciation  charges  used  in  these  calcula- 
tions are  the  same  as  those  given  above  in  tables  I  and 
II. 

As  Table  IV  contains  the  facts  upon  which  much  of 


this  part  of  the  discussion  is  based,  it  should  perhaps 
be  more  fully  explained.  The  figures  under  method  I 
therein  are  based  on  many  conditions.  Thus  it  has 
been  assumed  that  the  reserves  will  remain  in  the  busi- 
ness and  that  they  are  invested  partly  in  the  plant, 
partly  as  working  capital  and  partly  in  other  securities. 
As  no  portion  of  this  reserve  has  been  paid  out  to  the 
investors  for  the  reduction  of  the  capital,  it  is  held 
that  the  fair  value  of  the  property  is  its  cost  new. 
Since  the  reserve  is  thus  invested  in  a  manner  that  is 
likely  to  yield  the  highest  returns  that  can  be  obtained 
without  greater  risks,  the  depreciation  allowance  has 
been  computed  on  a  5  per  cent  sinking  fund  basis. 
For  interest  and  profits  8  per  cent  has  been  deemed  a 
fair  return.  The  total  amount,  under  this  method, 
that  the  customers  will  thus  have  to  bear  for  interest 
and  profits,  as  well  as  for  depreciation,  is  summarized 
in  column  V. 

The  figures  under  method  II  in  Table  IV  also  depend 
on  several  conditions.  In  the  first  place,  it  has  been 
assumed  that  $219,600  is  taken  out  of  the  reserve  during 
the  first  three  years  and  turned  over  to  the  investors 
and  that  this  resulted  in  reducing  by  that  much  the 
amount  of  capital  upon  which  interest  and  profit  is 
allowed.  That  is,  the  cost  new  of  the  property,  which 
was  first  placed  at  $1,000,000  has  been  reduced  by  the 
above  amount.  For  interest  and  profits,  8  per  cent 
has  been  considered  reasonable,  and  the  depreciation 
allowances  are  computed  upon  the  straight  line  basis. 
The  total  amounts  which  will  have  to  be  borne  by  the 


124  THE      UTILITIES      MAGAZINE 


customers  in  this  case  for  the  services  they  obtain  are 
shown  in  column  IX. 

In  connection  with  this  matter,  it  may  be  noticed 
that  in  using  $219,600  from  it  for  the  reduction  of  the 
investment  the  balance  in  the  reserve  for  all  of  the  years 
was  not  entirely  wiped  out.  In  view  of  this  fact  it 
might  perhaps  be  urged  that  these  balances,  though 
small,  might  still  be  productively  employed  for  the 
reserve  and  that  for  this  reason  it  is  not  entirely  fair 
to  make  no  allowance  for  this  in  computing  the  depre- 
ciation under  method  II.  In  answer  to  this  it  can  be 
said  that  it  is  seldom  either  safe  or  economical  to  use 
the  entire  balance  in  the  reserve  in  such  a  way  that  no 
portion  of  the  funds  therein  are  promptly  available  for 
emergencies  and  for  other  more  or  less  temporary  uses 
in  the  business.  Depreciation  is  also  of  such  nature 
that  it  cannot  always  be  correctly  estimated  in  advance. 
This  is  particularly  true  of  such  elements  therein  as 
inadequacy  and  obsolescence.  It  may  therefore  hap- 
pen at  almost  any  time  that  the  requirements  for  actual 
renewals  will  exceed  the  estimates.  As  already  pointed 
out,  the  balances  in  the  reserve  are  subject  to  wide 
fluctuations  from  other  causes.  It  also  often  happens 
in  actual  practice  that  readily  available  balances  can 
be  so  used  as  to  bring  about  considerable  savings  in 
the  operating  expenses  or  in  the  costs  upon  which  the 
customers'  rates  are  based.  In  view  of  these  and  other 
facts  of  this  kind,  it  is  not  only  likely  to  be  bad  practice, 
but  in  fact  exceedingly  hazardous  as  well  as  unfair  to 


the  management,  to  reduce  the  available  reserves  to 
the  last  penny  so  to  say. 

The  charges  that  will  have  to  be  borne  by  the  cus- 
tomers when  the  balance  in  the  reserve  is  used  produc- 
tively for  the  benefit  of  the  reserve  are  given  in  column 
V.  The  charges  that  the  customers  must  bear  when 
the  balance  in  the  reserve  is  applied  to  the  reduction 
of  the  capital  are  given  in  column  IX.  In  comparing 
the  results  in  the  two  cases,  it  is  found  that  the  interest 
and  depreciation  charges  that  must  be  borne  by  the 
customers  are  the  greatest  under  the  latter  method. 
In  fact,  they  exceed  these  charges  under  method  I  by 
about  $74,361  for  the  period. 

These  facts  tend  to  confirm  what  has  already  been 
intimated,  namely,  that  in  so  far  as  the  customers  are 
concerned,  there  seems  to  be  nothing  to  gain  by  using 
the  unexpended  balance  in  the  depreciation  reserve  for 
amortization  purposes  rather  than  productively  in 
connection  with  the  depreciation  reserve.  This  would 
probably  also  be  true  even  if  under  method  II  small 
amounts  could  be  placed  out  at  interest.  In  this  con- 
nection it  may  be  in  place  to  repeat  in  substance  some- 
thing that  has  already  been  said.  All  virile  and  live 
enterprises  are  constantly  in  need  of  readily  available 
funds  for  various  more  or  less  temporary  uses.  The 
ability  to  quickly  obtain  such  funds  often  stands  for 
material  savings  in  more  respects  than  one.  For  these 
and  other  reasons  it  may  not  be  in  line  with  the  best 
policy  to  place  too  many  restrictions  upon  the  balance 
in  the  depreciation  reserve. 


A    CRITICISM  OF  THEORETICAL  DEPRECIATION 

By  James  E.   Allison 

ComuUing   Engineer,  St.   Louis;   Lecturer   on   the   Economics  of  PuUic   Utilities,  Washington   University;  Former  Commissioner  and   Chief  Engineer, 

St.   Louis  Public  Service  Commission 


Gentlemen: 

We  have  just  heard  a  very  able  discussion  of  the  subject  of 
depreciation,  but  Mr.  Erickson's  paper  is  a  discussion  rather 
than  an  analysis  of  the  fundamentals.  He  takes  it  for 
granted  that  theoretical  depreciation  is  an  established  truth. 
In  this  I  must  differ  from  him. 

Led  by  the  Wisconsin  commission  a  number  of  the  state 
commissions  have  accepted  this  idea  of  theoretical  deprecia- 
tion, but  I  am  glad  to  be  able  to  say  that  at  least  two  of  our 
commissions  and  those  two  among  the  ablest  of  them  have 
repudiated  the  doctrine.  I  refer  to  the  commissions  of 
California  and  Massachusetts,  and  there  is  hope  that  others 
will  eventually  see  the  mistake  of  attempting  to  calculate 
the  earning  power  of  a  utility  by  using  the  erroneous  factor 
of  composite  remainder  of  Ufe. 

The  United  States  Supreme  Court  has,  I  believe  as  stated 
in  Mr.  Goetz's  paper,  never  clearly  endorsed  theoretical 


depreciation,  and  has  in  at  least  two  out  of  four  of  the  im- 
portant valuation  cases  inferentially  condemned  it. 

By  the  error  of  theoretical  depreciation  I  mean  the  prac- 
tice in  rate  cases  of  making  deduction  from  the  allowed 
earning  capital^of  the  utility  on  account  of  an  assumed 
lessening  of  value  by  reason  of  composite  age.  Whether  the 
deduction  is  calculated  by  use  of  the  straight  line  method  or 
by  the  sinking  fund  method  is  not  material  to  my  argument. 

Let  us  examine  briefly  the  process  by  which  a  depreciated 
value  (so  called)  is  arrived  at  under  the  workings  of  theoreti- 
cal depreciation. 

First  an  investigation  is  made  of  the  age  (not  the  condition) 
of  each  item  or  class  of  items  of  equipment  in  the  plant. 
This  results  in  a  composite  age  in  tlie  whole  plant. 

Next  an  estimate  of  the  expected  useful  life  of  each  item 
or  class  of  items  is  made  and  this  results  in  a  composite  esti- 
mated life  of  the  whole  plant. 


DEPRECIATION 


125 


Next  the  composite  age  is  deducted  from  the  composite 
estimated  hfe  and  the  result  is  a  composite  remainder  of  life 
expressed  in  a  percentage  of  the  full  estimated  composite 
hfe.  This  percentage  is  then  apphed  to  a  cost  of  the  depre- 
ciable property  and  the  result  is  said  to  be  the  present 
value. 

My  first  criticism  of  this  process  is  not  the  most  serious 
one,  but  it  should  appear  very  serious  to  men  who  as  com- 
missioners or  public  officials  are  charged  with  the  duties  of 
doing  even  handed  justice  between  their  fellow-citizens,  the 
consumers,  on  one  hand,  and  their  no  less  fellow-citizens, 
the  owners  of  the  utility  plant  on  the  other  hand.  This 
criticism  is  the  utter  and  absolute  unreUability  of  the  esti- 
mates of  expected  life  of  the  items  of  equipment  in  any  given 
utihty  plant.  I  am  sorry  to  have  to  admit  that  through 
neglect  or  lack  of  thought  or  even  on  account  of  vanity  in 
not  honestly  admitting  ignorance  of  the  unknowable,  the 
engineers  as  a  body  have  not  sufficiently  emphasized  the 
extremely  speculative  character  of  estimates  of  life  of  major 
items  of  equipment  in  utihty  plants.  The  result  has  been 
that  commissions,  while  mildly  stating  that  estimated  life 
may  have  some  speculative  elements,  nevertheless  act  upon 
the  assumption  that  there  is  sufficient  reliability  in  the 
estimates  to  justify  the  determination  of  amounts  vital  to 
the  justice  which  they  are  supposed  to  administer. 

One  of  the  superficially  plausible  but  specious  aspects  of 
the  estimated  lives  of  equipment  put  forward  by  different 
engineers,  is  a  certain  apparent  agreement  of  figures  in  the 
life  tables  of  the  different  estimates.  This  very  agreement 
is  an  evidence  of  the  unreliability  of  the  estimates  as  appUed 
to  any  given  plant. 

Sometimes  it  is  assumed  that  these  lives  are  averages. 
This  is  not  true,  for  with  very  feW  exceptions  there  have  been 
no  reliable  hfe  data  collected.  Owing  to  the  development 
of  the  arts  in  utility  equipment,  replacements  in  the  past  have 
not  as  a  rule  been  made  in  the  same  type  of  equipment  as  the 
removals,  and  generally  speaking  (there  are  exceptions  of 
course)  there  has  been  httle  opportunity  of  compihng  aver- 
ages even  if  averages  could  be  of  any  use  after  they  were 
compiled. 

The  life  of  equipment  depends  considerably  upon  the  degree 
of  maintenance  and  the  character  of  use  given  it  in  the  uidi- 
vidual  plant  to  which  it  belongs,  but  even  if  we  ehminated 
these  as  factors  of  variance,  we  find  that  the  life  of  major 
equipment  will  depend  mainly  on  the  changes  in  the  arts 
resulting  in  obsolescence  and  on  the  changes  in  the  demand 
for  service,  resulting  in  inadequacy. 

The  life  of  the  equipment  is  individual  to  the  plant,  and 
can  only  be  estimated  within  such  wide  limits  as  to  make  the 
result  in  figures  entirely  unsuitable  for  use  in  the  very  respon- 
sible task  of  determining  the  earning  power  of  property,  serv- 
ing the  public. 

So  much  for  the  reliability  of  the  basic  figures  upon  which 
theoretical  depreciation  rests.  But  even  supposing  them  to 
be  reliable  let  us  examine  their  appUcation. 

As  I  have  said:  we  have  first  the  composite  age  of  the 
property.  This  is  deducted  from  the  composite  estimated 
life  of  the  property,  and  the  result  is  a  per  cent  remainder 


of  composite  life.  This  apphed  to  a  cost  is  used  to  determine 
the  value  or  earning  power  of  the  physical  plant. 

To  my  mind  a  sufficient  bar  to  the  use  of  such  a  method  is 
the  fact  that  there  is  in  reality  no  such  thing  as  a  composite 
life  of  a  utUity.  The  life  of  a  going  plant  extends  on  indef- 
initely into  the  future  with  no  determinable  end,  and  to  base 
a  calculation  of  value  upon  the  assiunption  of  a  remainder 
of  life  for  the  utihty  as  a  whole,  is  in  the  face  of  this  fact 
almost  an  absurdity. 

It  should  not  need  argument  to  show  that,  if  renewals  are 
made  when  necessary,  a  plant  has  no  determinable  life,  and 
that,  if  there  is  to  be  a  theoretical  per  cent  deduction  for  age, 
this  deduction  would  be  infinitely  small  when  applied  to  the 
really  almost  infinite  expectation  of  the  fife  of  the  utihty. 

This  argument  has  sometimes  been  met  by  the  advocates 
of  theoretical  depreciation  with  the  statement  that  they  are 
not  considering  renewals  but  only  the  existing  physical 
property.  But  if  the  stand  is  taken  that  renewals  are  not 
to  be  considered,  then  the  useful  life  of  the  plant  is  not  the 
composite  remainder  of  life  as  estimated,  but  its  hfe  wiU  only 
extend  to  the  time  when  the  first  vital  part  goes  out.  In 
other  words,  following  theoretical  depreciation  to  its  logical 
conclusion  very  few  plants  would  have  a  value  much  above 
scrap. 

The  fundamental  mistake  which  has  been  made  in  apply- 
ing theoretical  depreciation  is  in  assuming  that  an  item  in 
the  plant  and  the  whole  plant  are  of  a  similar  nature.  It  is 
true  that  the  different  items  of  equipment  have  an  end.  But 
the  plant  as  a  whole  has  not.  If  properly  treated  as  to  main- 
tenance and  replacement  it  pursues  its  course  indefinitely, 
giving  the  required  service,  and  in  its  normal  state  always 
representing  the  full  amount  of  capital  efficiently  placed  in 
the  pubhc  service  to  produce  it. 

So  far  as  age  and  the  different  parts  go,  they  produce  a 
normal  condition  of  the  plant  as  to  replacement,  which  normal 
condition  is  the  only  kind  of  a  plant  possible  of  continuance 
and  the  only  kind  of  a  plant  which  the  investor's  money  can 
permanently  produce. 

As  the  minds  of  the  advocates  of  theoretical  depreciation 
seem  to  confuse  the  nature  of  the  item  of  equipment  with 
the  entirely  different  nature  of  the  whole  utihty,  let  me  illus- 
trate by  supposing,  we  will  say,  an  engine  of  such  a  nature 
that  not  only  repairs  can  be  made  but  also  obsolescence  and 
inadequacy  be  coimteracted  piecemeal  when  required.  I 
think  it  will  have  to  be  admitted  that  such  an  engine  would 
last  almost  indefinitely  and  would  not  depreciate  provided 
its  parts  were  properly  renewed.  Utility  plants  of  any  size 
are  exactly  similar  to  such  an  engine,  and  so  long  as  they  are 
fully  kept  up  do  not  depreciate  in  real  value. 

Much  of  the  confusion  of  thought  connected  with  the 
depreciation  problem  has  been  brought  about  by  the  question 
of  charges  and  funds  labeled  by  accountants  depreciation 
funds  or  depreciation  charges.  They  should  be  called  re- 
placement charges  or  replacement  funds,  for  that  should 
be  their  purpose. 

When  replacement  is  fully  provided  for,  depreciation  is 
counteracted,  and  does  not  exist,  and  so-called  depreciation 


126 


THE      UTILITIES      MAGAZINE 


charges  should  be  made  in  rates  with  the  puipose  of  counter- 
acting or  preventing  depreciation  by  replacement. 

The  calculation  of  theoretical  depreciation  when  applied 
to  the  future  of  a  supposedly  new  plant  today  will  produce 
as  mentioned  by  Mr.  Erickson  a  surplus  or  fund  which  cannot 
be  used  for  replacement.  It  is,  therefore,  assumed  that  this 
fund  having  been  allowed  in  the  rate  over  and  above  a  rea- 
sonable return  does  not  belong  to  the  owners  of  the  utility 
plant,  and  if  it  is  given  to  them,  a  like  amount  should  be 
deducted  from  their  investment;  in  short,  the  transaction 
should  be  treated  as  a  part  purchase  of  the  plant  by  the 
consumer. 

In  ethics,  perhaps,  there  can  be  no  serious  objections  to 
this  proceeding  where  it  is  confined  to  instances  in  the  future 
where  the  charges  which  produce  this  surplus  (wrongly 
called  depreciation  fund)  shall  have  been  specifically  added 
to  the  rate  paid  by  the  consumer  for  the  understood  purpose 
of  providing  such  a  surplus  or  depreciation  fund. 

The  whole  transaction  is  entirely  unnecessary  and  futile, 
but  if  a  company  wishes  to  sell  a  part  of  its  plant  to  the  public, 
and  the  public  wishes  to  buy,  the  affair  is,  perhaps,  in  so  far 
as  the  future  plant  is  concerned,  harmless,  but  has  really 
nothing  to  do  with  the  value  of  the  plant  except  that  the  part 
purchase  is  made  under  the  guise  of  a  reduction  in  value. 

I  have  said  that  there  would  be  no  great  harm  in  such  a 
procedure,  if  it  were  clearly  understood  that  the  resulting  re- 
duction of  the  earning  power  of  the  utility  were  compensated 
for  to  the  investor  by  a  fund  expressly  collected  from  the 
consumer  for  that  purpose.  But  while  this  process  might 
result  in  no  injustice  when  properly  applied  to  the  future, 
it  has  become  extremely  dangerous  to  just  administration 
when  applied  to  the  past  or  unregulated  stage  of  the  public 
utility. 

In  plain  words,  it  is  now  often  in  effect  assumed  by  com- 
missions that  the  owners  of  a  utility  should  have  in  the  past 
set  aside  a  fund  out  of  their  profits  for  the  purpose  of  buying 
a  part  of  the  plant  from  themselves  and  giving  it  to  the  con- 
sumer. 

The  theory  does  not  appear  in  this  guise,  but  that  is  what 
it  is  nevertheless,  and  the  so-called  theoretical  depreciation 
fund  if  it  exists,  as  a  surplus  over  the  needs  of  replacement 
requirements,  is  nothing  but  a  purchase  fund  unwittingly 
provided  out  of  their  legal  profit  by  the  owners  of  the  plant 
and  used  by  the  commissions  to  buy  a  part  of  the  plant  for 
the  consumer. 

If  the  fund  does  not  exist,  so  much  the  worse  for  the  owner. 
The  commissions  take  away  a  part  of  the  plant  anyway 
under  the  plea  that  the  company  should  ia  the  past  have  set 


aside  a  fund  to  make  the  purchase  for  the  consumer.  This, 
of  course,  is  said  in  other  words  and  other  terms  are  used; 
but  the  result  is  the  same. 

There  are  some  who  flatly  claim  the  right  of  regulating 
today  past  profit  through  the  device  of  theoretical  depre- 
ciation. I^et  us  see  where  such  an  assumption  will  lead. 
Past  profits  if  legal  were  legally  acquired  property  no  matter 
whether  we  now  think  them  excessive  or  not.  Imagine  giv- 
ing any  body  of  men  power  to  take  away  legally  acquired 
property  because  they  do  not  approve  of  the  way  in  which  it 
was  acquired.  Yet  this  power  is  unwittingly  assumed  under 
the  guise  of  theoretical  depreciation  when  they  compel  a 
company  to  buy  a  part  of  its  own  property  for  the  consumer 
out  of  the  legally  acquired  profits  of  the  past.  Remember 
that  in  the  past  the  consumer  gave  nothing  for  theoretical 
depreciation  in  his  rate.  Theoretical  depreciation  was  un- 
thought  of  either  by  utility  owners  or  public  officials,  and 
the  plain  and  sound  view  prevailed,  that  in  a  continuous 
business  full  replacements  offset  depreciation  and  the  fact 
was  recognized  that,  so  long  as  a  plant  now  and  in  the  future 
is  assured  of,  efficiently  and  continuously  performing  its 
functions,  there  is  no  lessening  of  value  so  far  as  plant  is 
concerned. 

Right  here  I  wish  to  say  that  I  should  regret  very  much 
to  be  misunderstood  as  attributing  to  commissions  the 
desire  to  unjustly  cut  down  the  earning  capital  of  the  utility 
under  their  power  and  protection.  In  attacking  theoretical 
depreciation,  I  find  its  advocates  almost  as  strong  among 
the  company's  representatives,  as  among  the  commissions, 
while  those  who  disapprove  of  it,  and  to  my  mind  see  its 
error,  are  also  distributed  between  the  commissions  and  the 
companies. 

The  problem  has  so  many  elusive  aspects  that  honest  dis- 
agreement will  probably  last  for  some  time  to  come. 

To  some  minds  the  statement  that  a  plant  which  is  not 
new  cannot  have  a  value  as  great  as  its  cost,  appeals  as 
sound  reasoning.  They  seem  unable  to  grasp  the  truth  that 
cost  and  abstract  age  do  not  measure  value,  and  that  to  try 
to  combine  them  as  factors  in  a  calculation  of  value,  is  like 
multiplying  apples  by  potatoes  with  the  expectation  that 
the  result  will  be  peaches.  Nor  is  it  perceived  that  to  seek 
to  find  value  in  the  sense  of  exchange  value  is  an  error  even 
before  the  method  of  such  calculation  is  reached.  In  a  rate 
case  a  determinable  value  does  not  exist  until  after  the  rates 
are  made  and  the  resultant  earnings  demonstrated,  so  that 
in  taking  abstract  age  and  cost  as  factors  to  arrive  at  the 
value  a  double  mistake  is  made,  first,  in  the  factors  used; 
second,  in  the  purpose  of  the  calculation. 


DEPRECIATION 


127 


DISCUSSION 

By  John  Bauer 

Assistant  Professor  of  Economics,  Cornell  University 


/    It  seems. to  me  that  the  relation  of  depreciation  to  fair 

value  depends  altogether  on  the  basis  of  valuation  that  we 

)  decide  to  use.     If  the  basis  selected  should  be  exchange  value, 

,     /  as  Mr.  Allison  seems  to  have  assumed  in  his  discussion,  then, 

'    /    of  course,  there  is  no  valid  ground  for  deduction  on  account 

"S     of  depreciation.     On  that  basis  we  may  have  a  tremendous 

)    job  in  any  case  to  establish  the  proper  valuation;  but  when 

/     we  have  made  the  determination,  however  we  may  have 

I     reached  it,  we  cannot  very  well  depreciate  it.     This  matter 

^-should  be  quite  obvious. 

In  presenting  his  theory  of  depreciation,  is  Mr.  Allison 
talking  about  exchange  value?  Does  he  consider  that  as 
the  proper  basis  of  valuation  in  rate  cases?  If  he  does,  then 
we  better  close  up  shop ;  quit  any  further  attempts  at  regula- 
tion; and  let  the  companies  charge  such  rates  as  they  can 
under  the  theory  of  what  the  traffic  will  bear.  Mr.  Stevens 
last  night  assured  us  that  he  has  a  method  worked  out  by 
which  he  could  regulate  rates  on  the  basis  of  exchange  value 
and  still  provide  for  a  reduction  of  any  existing  high  rates. 
Personally  I  agree  with  Mr.  Eshleman:  I  don't  see  how  that 
can  be  done.  I  have  puzzled  over  this  question  considerably; 
of  course,  so  has  Mr.  Stevens,  and  so  has  everybody  else 
here.  No  one  but  Mr.  Stevens,  except  perhaps  also  Mr. 
Allison,  seems  to  comprehend  how  a  reduction  in  rates 
may  be  effected  under  the  exchange  value  theory.  If  Mr. 
Stevens  has  a  method,  it  seems  to  me  we  ought  to  give  him 
not  fifteen  minutes  or  half  an  hour,  but  all  the  time  that  he 
needs,  to  explain  his  magic.  He  would  perform  a  great 
service  in  demonstrating  how  the  circle  of  exchange  value 
and  rates  may  be  squared. 

If  it  is  exchange  value  on  which  we  are  going  to  base 
rates,  let  us  be  clear  about  the  matter.  In  that  case  there 
should  be  no  further  discussion  of  depreciation.  Let  me 
repeat:  you  cannot  depreciate  exchange  value,  nor  could 
you  reduce  rates.  But  if  that  is  not  the  basis  that  we  wish, 
then  let  us  make  clear  for  ourselves  what  we  do  want. 
Whether  or  not  we  should  allow  for  depreciation  will  depend 
upon  the  particular  basis  of  valuation  that  we  select. 

We  have  heard  the  distinction  again  and  again  between 
actual  cost  and  reproduction  cost.  While  this  distinction 
seems  in  general  fairly  clear,  it  is  not  as  definite  as  the 
terminology  implies.  Suppose  we  were  to  say  that  it  is 
actual,  not  reproduction  cost,  upon  which  we  are  going  to 
base  rates.  What  is  actual  cost?  There  are  several  distinct 
concepts.  Do  you  mean  the  money  or  direct  capital  actually 
furnished  by  the  security  holders?  Or  cash  or  its  equivalent 
put  directly  into  property  through  the  issue  of  securities? 
If  that  is  what  you  mean  by  actual  cost,  it  seems  to  me  that 
again  there  would  be  no  ground  for  any  deduction  on  account 
of  depreciation.  If  you  can  find  by  the  inspection  of  past 
records,  or  if  you  can  discover  definitely  in  any  way  what  the 
money  actually  was  that  was  put  into  the  business  through 
the  issue  of  securities,  that  ends  the  matter.     The  sum 


would  be  a  definite  historical  fact, — if  you  could  find  out 
what  it  is, — not  subject  to  depreciation. 

There  are  several  other  concepts  of  actual  cost  than  the 
one  just  presented,  and  the  speakers  have  not  always  made 
clear  precisely  what  they  meant.  In  general,  we  may  look 
upon  actual  cost  as  a  measure  of  sacrifice  incurred  by  the 
security  holders  or  investors  of  the  business,  or  we  may  look 
upon  the  physical  property  used  in  the  public  service;  the 
one  view  regards  the  investors  as  such,  while  the  other  con- 
siders the  physical  property.  But,  if  we  take  simply  the 
first  view,  namely,  sacrifice  of  the  investors,  there  are  several 
concepts  that  should  be  carefully  distinguished, — and  with 
none  of  these  as  the  basis  would  depreciation  be  a  question 
in  determining  the  valuation  on  which  a  return  would  be 
allowed.  One  of  these  sacrifice  ideas  has  already  been 
considered:  the  cash  or  equivalent  put  directly  into  the 
business  through  the  issue  of  securities;  under  proper 
accounting  this  would  be  shown  by  the  par  value  of  the 
securities  outstanding,  plus  or  minus  any  actual  premiums 
or  discounts.  A  second  sacrifice  basis  would  include  the 
above,  together  with  all  reinvestment  of  past  earnings;  this 
would  normally  be  shown  under  proper  accounting  by  the 
securities  outstanding,  plus  or  minus  premiums  and  discounts, 
plus  any  surplus  accumulated  out  of  earnings.  A  third 
view  would  include  also  operating  deficits  or  deficiency  in 
return  suffered  by  investors,  and  a  fourth  would  provide  as 
an  offset  to  the  sacrifice  any  excessive  return  realized  by 
investors.  Which  of  these  possible  ideas  do  we  have  in 
mind  when  we  speak  of  sacrifice  as  the  proper  valuation  on 
which  a  return  should  be  based? 

Let  me  repeat:  with  none  of  these  actual  cost  concepts  is 
there  logical  room  for  depreciation  deduction.  In  any  case, 
the  result  would  be  an  historical  matter  which  would  have  no 
possible  connection  with  the  physical  condition  of  the  prop- 
erty. Some  of  the  speakers  have  seemed  to  imply  the  fourth 
basis  as  the  cost  that  they  mean — but  I  have  not  felt  certain 
as  to  that, — namely,  the  funds  put  into  the  property  through 
the  issue  of  securities,  plus  investment  of  earnings,  plus  all 
operating  deficits  and  deficiency  in  reasonable  return  on 
investment,  minus  all  excessive  returns.  We  may  call  this 
for  the  sake  of  definiteness  the  "net  sacrifice  to  investors" 
or  simply  the  "net  sacrifice"  basis.  This  view  is  very 
attractive.  It  squares  with  an  ideal  relation  between  the 
public  and  the  investors;  that  the  latter  are  entitled  to  a 
fair  return  and  no  more;  if  they  get  less,  the  deficiency 
would  be  added  to  the  investment,  and  if  more,  the  excess 
would  be  deducted.  In  any  case,  the  proper  valuation 
would  require  an  analysis  of  the  company's  records  as  to  the 
securities  issued  and  the  returns  realized  by  investors.  The 
primary  determination  would  be  the  money  or  equivalent 
directly  put  into  the  business  through  the  issue  of  securities. 
The  secondary  calculation  would  require  a  minute  analysis 
of  the  entire  operating  history  of  the  company,  from  its 


128 


THE      UTILITIES      MAGAZINE 


beginning  to  the  time  of  the  rate  proceedings.  A  fair  rate 
of  return  would  have  to  be  assumed,  and  on  the  basis  of  this 
rate,  any  deficiency  in  return  realized  by  investors  would 
have  to  be  added  to  the  primary  valuation  and  any  excessive 
return  would  have  to  be  deducted.  Compound  interest 
allowance  would  have  to  be  made  in  the  calculation, — ^both 
in  case  of  additions  to  and  subtractions  from  the  primary 
figure. 

As  stated  before,  the  net  sacrifice  theory  is  attractive, 
but  we  should  be  clear  as  to  its  fidl  significance  when  we 
urge  its  adoption.  As  to  depreciation,  of  course,  there 
would  be  no  room  for  any  deduction.  Undoubtedly  in 
determining  the  desirable  basis  of  valuation  we  should  have 
chief  regard  to  justice  and  broad  economic  considerations. 
In  a  sense,  the  net  sacrifice  presents  a  high  ideal  of  justice, 
but  I  doubt  very  much  whether  it  offers  a  reasonable  way 
to  proceed  with  existing  investments.  If  investors  had 
known  all  along  that  the  method  would  be  used,  it  would, 
of  course,  be  fair  and  satisfactory.  But  they  have  not 
known,  and  in  many  cases  grave  injustice  would  be  inflicted 
if  it  were  to  be  adopted  for  the  valuation  of  existing  properties. 
In  many  cases,  the  deficiency  in  return  has  been  so  great 
that  the  net  sacrifice  would  present  a  figure  on  which  the 
company  could  never  earn  a  reasonable  return.  In  such 
instances  the  business  was  ill-conceived,  and  the  investors 
never  can  get  a  full  return  on  their  entire  sacrifice;  they 
cannot  avoid  loss,  however  high  the  rates  may  be  placed. 
The  addition  to  the  primary  investment  would  be  of  no  use 
in  making  good  past  losses  incurred  in  behalf  of  the  public. 
There  would  be  plenty  of  instances,  however,  where  past 
deficiencies  could  be  made  good  through  future  rates,  and 
where  the  addition  to  the  primary  investment  would  therefore 
be  greatly  advantageous  to  the  investors. 

In  judging  the  practicability  of  the  method,  we  must 
consider  what  can  be  done  or  reasonably  should  be  done,  if 
there  have  been  excessive  returns  in  the  past.  In  such 
cases,  and  they  are  numerous,  would  it  be  feasible  to  make 
deductions  from  the  direct  investment  on  account  of  past 
earnings?  If  we  were  to  do  so,  and  were  to  follow  the 
method  consistently  throughout,  clearly  in  many  cases  the 
investment  would  be  reduced  to  a  nominal  figure  or  would 
be  wiped  out  altogether.  In  extreme  cases,  and  they 
probably  would  not  form  a  negligible  number,  not  only  would 
the  existing  investment  be  wiped  out,  but  the  stockholders 
would  find  themselves  personally  indebted  to  the  public. 
Could  the  public  collect  the  debt.''  Considering  our  social 
policies  in  the  past  and  our  fundamental  views  of  law, 
would  it  be  practical  to  deduct  from  the  direct  investment 
even  if  the  result  would  still  leave  a  nominal  amount  for 
future  return?  Would  it  be  possible  or  expedient  to  make 
any  deductions  from  a  primary  valuation  on  account  of  past 
earnings  which  were  due  to  rates  that  were  legally  permitted 
to  exist? 

We  may  argue,  of  course,  that  at  any  time  all  the  investors 
were  entitled  to  receive  was  a  fair  return  on  the  investment 
placed  at  the  service  of  the  public.  We  have  had  a  right  to 
regulate;  if  they  have  received  a  fair  return,  then  any  excess 
was  more  than  the  public  should  have  been  charged,  and  the 


amount  should  be  deducted  from  the  investment.  This 
logic  is  rigorous;  the  diflSculty  is,  while,  of  course,  we  have 
had  the  right  to  regulate,  the  right  has  not  been  so  clearly 
defined  as  assumed,  and  the  fact  remains,  we  have  not 
exercised  it.  Could  investors  have  reasonably  expected 
under  the  laws  as  they  have  been  interpreted,  that  excess 
returns  would  be  deducted  from  their  investment?  If  so, 
then  they  had  their  eyes  open,  and  the  deduction  should  bie 
made.  But,  no  one  would  seriously  urge  that  any  such 
view  has  been  held  by  any  considerable  proportion  of  the 
public;  certainly  not  by  our  lawmaking  bodies  and  the  courts. 
No  American  legislature  would  now  consent  to  such  a 
poUcy;  if  any  did,  an  enactment  embodying  the  principle 
woidd  certainly  be  annulled  by  the  courts. 

Personally,  I  should  consider  the  net  sacrifice  basis  un- 
workable as  to  existing  investments,  but  it  may  very  well  be 
apphed  to  future  investments.  But  before  considering 
future  policy,  I  should  like  to  present  stUl  another  actual  cost 
concept,  which  I  beheve  is  the  only  one  that  may  be  prac- 
tically applied  to  existing  investments,  and  which  does 
bring  up  the  question  of  deduction  for  depreciation.  With 
this  concept,  we  turn  from  the  securities  outstanding  or  the 
investors  as  such,  and  view  simply  the  property  in  service. 
This  property  may  be  inventoried  and  appraised  on  the 
basis  of  costs  or  prices  at  the  time  of  installation.  The 
result  would  be  the  actual  cost  of  the  property,  instead  of  the 
reproduction  cost,  which  has  been  extensively  considered 
in  the  Conference.  This  is  not  an  historical  view;  it  would 
not  regard  the  funds  provided  by  security  holders  nor  the 
returns  that  have  been  realized  during  the  life  of  the  business. 
It  would  consider  only  the  property  in  service  at  the  time 
of  the  valuation  and  would  provide  for  appraisement  at 
prices  when  the  particular  units  of  property  were  installed. 
Then  after  the  appraisal  is  completed,  based  on  installation 
costs,  the  question  would  then  arise  whether  any  deduction 
shoidd  be  made  on  account  of  the  physical  condition  of  the 
property.  Should  any  deduction  be  made  on  account  of 
depreciation? 

As  a  further  basis  of  valuation,  we  may  take  reproduction 
cost.  Let  me  briefly  point  out,  without  extensive  discussion, 
that  this  method  is  more  directly  comparable  to  the  actual 
cost  just  presented,  i.e.,  appraisal  of  property  at  installation 
prices,  than  to  the  various  investors'  sacrifice  concepts 
previously  reviewed.  Reproduction  cost  is  an  appraisal 
concept,  regarding  the  property  in  service,  and  not  a  sacrifice 
idea  with  the  view  centered  on  the  investors  in  the  business. 
It  would  require  a  physical  appraisal  of  the  property  in 
service,  placing  the  valuation  at  present  prices  of  labor  and 
materials.  After  the  primary  valuation  is  completed,  then 
the  question  would  come  up,  just  as  under  the  instaUation 
cost  method,  whether  any  deductions  should  be  made  on 
account  of  the  physical  state  of  the  property. 

From  the  general  valuation  concepts  that  I  have  briefly 
outlined,  it  should  be  clear  that  the  question  of  depreciation 
logically  arises  only  in  case  of  physical  appraisal,  when  we 
disregard  the  securities  outstanding  or  the  investors,  and  look 
upon  the  property  itself.  It  seems  to  me  that  practically  we 
shall  be  compelled  to  adopt  an  appraisal  method.    Any  of  the 


DEPRECIATION 


129 


investors'  sacrifice  concepts  would  be  unworkable,  partly 
for  the  reasons  already  suggested  and  partly  because  the 
records  in  most  cases  are  incomplete,  so  that  the  investment 
could  not  be  determined  except  as  a  more  or  less  justifiable 
guess.  At  any  rate,  here  we  are  with  the  various  possible 
bases  of  valuation;  the  question  before  us  is,  which  shall  we 
select  as  the  most  reasonable?  For  the  future,  there  is 
probably  little  difference  of  opinion  or  we  could  come  to  an 
agreement.  Any  one  of  the  invention  sacrifice  theories 
might  be  used.  I  should  prefer  the  first  concept  presented 
above,  the  funds  put  into  the  business  through  the  issue  of 
securities.  We  could  then  look  directly  to  the  securities, 
their  salary  to  show  the  investment.  The  regulation  of 
security  issues  would  insure  that  none  would  be  made  except 
for  actual  funds  put  into  the  business.  My  notion  would  be 
that  only  such  returns  should  be  allowed  to  investors  as  is 
clearly  stipidated  on  the  securities  issued,  with  except 
possibly  an  addition  as  bonus  for  efficiency  of  service.  Any 
excess  earnings  of  the  business  should  go  to  the  state  or 
municipality  in  the  form  of  a  franchise  tax.  If  this  policy 
were  definitely  fixed,  there  could  be  no  possible  injustice; 
investors  would  know  what  risks  they  were  taking;  the 
rate  of  return  on  which  the  securities  could  be  issued  would 
be  determined  accordingly;  the  determination  of  investment 
and  return  could  be  made  easily  an  automatic  matter,  based 
on  accounting  control  of  the  companies. 

For  the  future  such  a  policy  seems  to  me  essential  if  we 
are  going  to  get  anywhere  with  regulation.  It  would  provide 
for  definite  and  automatic  control,  and,  if  the  risks  were  made 
clear  to  the  investors,  it  would  be  just  to  them.  The  diffi- 
culty is  as  to  existing  properties:  how  shall  we  treat  them? 
Frankly  here  we  face  a  confusion.  It  seems  to  me,  again, 
if  we  are  going  to  get  anywhere  with  regulation  in  the  future, 
we  should  work  out  a  reasonable  valuation  policy  and  apply 
it  throughout  to  all  companies  as  to  their  existing  properties. 
I  believe  that  as  soon  as  practicable  we  should  place  a 
valuation  upon  every  existing  investment  in  line  with 
the  policy  that  we  may  select,  and  then  for  the  future  allow  a 
fair  return  on  the  amount  and  no  more,  and,  as  already  stated, 
allow  a  fair  return  also  on  all  additional  investments  and  no 
more.  If  this  were  done,  regulation  of  return  would  become 
a  definite  and  automatic  matter,  and  we  should  be  free 
from  the  time-consuming,  costly,  irritating  and  unsatisfactory 
proceeding  in  present  rate  cases.  I  should  like  to  continue 
with  the  details  of  this  scheme,  but  cannot  for  lack  of  time. 
I  merely  present  the  outline  of  the  plan  of  regulation  which 
seems  to  me  desirable  for  the  future,  which  would  really 
make  public  utilities  the  public  agencies  that  we  consider 
them  to  be. 

The  practical  question,  then,  that  we  face  is,  what  reason- 
able basis  of  valuation  shall  we  adopt  for  the  valuation  of 
existing  properties?  This  is  not  a  question  of  establishing 
exchange  value,  but  one  of  formulating  a  broad  pubhc  pohcy 
which  is  fair  to  investors  and  at  the  same  time  provides  the 
definite  control  of  utilities  that  we  desire.  This  is  properly 
a  legislative  matter,  as  Mr.  Anderson  pointed  out  in  his  paper, 
and  undoubtedly,  if  a  reasonable  policy  were  presented  by  a 
legislature,  it  would  receive  judicial  sanction.  One  of  the 
9 


chief  considerations  of  the  pohcy  should  be  justice  to  inves- 
tors, but  we  should  look  primarily  to  broad  social  and  not  to 
narrow  personal  justice.  If  we  are  guided  by  the  narrower 
individual  view,  we  are  bound  to  defeat  more  or  less  the 
reasonable  social  claims  for  definite  control.  We  shoidd 
adopt  a  policy  that  is  sensible,  which  will  not  permit  endless 
discussion  of  detail,  particularly  which  is  definite  and  can 
be  appUed  in  the  same  way  to  all  cases. 

It  seems  to  me  that  we  must  give  up  as  unworkable  the 
standards  set  by  the  Supreme  Court  of  the  United  States  in 
Smythe  vs.  Ames;  that  in  any  case  we  must  consider  the 
actual  cost  of  the  property,  the  reproduction  cost,  the  par 
and  market  value  of  securities,  etc.  This  means,  and  there 
seems  to  be  some  opinion  here  at  the  Conference  in  favor 
of  this  view,  that  the  basis  of  valuation  employed  should  be 
determined  according  to  the  circimistances  of  each  case. 
Now,  I  beheve,  that  if  we  look  at  this  proposition  squarely, 
we  must  admit  that  it  will  not  work.  To  get  anywhere  in 
practice  we  must  lay  down  rules  that  can  be  reasonably 
understood.  The  principal  difficulty  now  is,  we  have  not 
laid  down  definite  rules;  we  have  allowed  ourselves  to  drift 
and  we  are  still  drifting.  Of  course,  a  certain  amount  of 
drifting  is  necessary  until  one  gets  his  bearings.  I  take  it, 
however,  that  the  purpose  of  this  Conference  is  chiefly  for  the 
purpose  of  getting  our  bearings  and  of  determining  the  best 
method  to  proceed.  We  are  not  bound  by  technical  court 
rules;  we  are  free  to  consider  what  is  best  to  do.  The  absence 
of  clear  rules  of  valuation  accounts  largely  for  the  efforts 
of  the  company  in  any  case  to  m-ge  as  many  different  elements 
of  value  as  possible,  for  the  interminable  discussion,  the 
dragging  out  of  the  hearings,  the  great  expense,  and  the 
many  unsatisfactory  decisions.  If  we  really  expect  to 
regulate,  we  must  have  rules  which  moderately  intelligent 
men  can  understand  and  which  can  be  reasonably  applied, 
without  inordinate  time  and  expense  attached  to  the  valua- 
tion proceeding. 

In  deciding  upon  a  clear  rule  to  apply  to  existing  invest- 
ments, there  are  the  various  concepts  that  I  have  reviewed, 
and  there  are  others.  As  already  brought  out,  the  investors' 
sacrifice  concepts  are  attractive  but  unworkable,  partly 
because  of  the  difficulty  in  most  cases  to  determine  the 
amount  of  the  sacrifice,  and  partly  because  of  the  extreme 
positions  to  which  their  logical  application  leads.  Still,  so 
far  as  possible,  it  seems  to  me  we  should  make  the  method 
adopted  for  existing  investments  as  consistent  as  possible 
with  the  rule  applied  to  future  investments.  For  practical 
considerations,  it  seems  to  me  we  are  bound  to  adopt  an 
appraisal  idea,  looking  upon  the  existing  property  in  any 
case,  and  disregarding  the  secm-ities  outstanding  or  the 
sacrffice  of  the  investors.  If  we  do  decide  upon  appraisal, 
we  face  two  workable  alternatives,  actual,  or  more  precisely, 
installation  cost,  and  reproduction  cost;  appraisal  at  prices 
when  the  different  major  units  of  the  property  were  installed, 
or  at  present  prevailing  prices.  Which  basis  is  the  more 
reasonable? 

Frankly,  for  the  sake  of  obtaining  definite  control  for 
the  future,  I  should  be  willing  to  accept  reproduction  cost. 
Still,  it  seems  to  me,  installation  cost  would  be  the  more 


130 


THE      UTILITIES      MAGAZINE 


reasonable.     It  would  conform  more  nearly  to  the  rule  that 
we  all  agree  should  be  applied  to  future  investments.    Fur- 
ther, if  proper  accounting  has  been  followed  in  any  case, 
the  installation  cost  appraisal  would  correspond  with  the 
book  cost  shown  by  the  accounts  of  the  company.     In  the 
average  case,  it  seems  to  me,  the  policy  would  measure  up 
with  our  ideals  of  justice,  giving  the  investors  credit  for 
what  they  fairly  deserve  or  could  reasonably  expect.     But, 
of  course,  in  many  cases  there  would  be  past  losses  that  would 
not  be  recouped, — ^but  also  there  would  be  many  cases  of  past 
excessive  profits  which  woidd  not  be  counted  against  the 
valuation.     We  should  draw  a  curtain  on  the  past  so  far 
as  personal  sacrifice  and  return  are  concerned.    The  policy 
is  for  the  future,  with  still  reasonable  consideration  for  vested 
interests.     On  the  average  installation  cost  would  not  only 
come  up  fairly  to  our  ideals  of  general  justice,  but  at  the 
same  time  would  conform  well  to  our  measure  of  future 
investment.    Along  broad  social  lines,  the  method  seems 
to  me  the  one  that  is  just  and  expedient,  and  the  one  to 
be  adopted. 
y^      In  order  to  make  the  method  easily  workable,  it  seems  to 
me  that  it  could  well  be  applied  on  the  basis  of  averages. 
Minute  inventories  would  not  be  necessary,  and  exact  prices 
at  the  time  each  unit  of  plant  was  installed  would  not  need 
to  be  used.     For  physical  plant,  we  might  very  well  determine 
average  unit  prices  for  the  past  ten  years,  and  apply  them 
throughout  to  the  inventories  in  each  case.    This  procedure 
would  probably  give  as  rehable  results  as  any  hair  splitting 
determination.     In  the  case  of  land,  however,  there  usually 
would  be  no  difficulty  in  determining  the  exact  purchase 
price,  and  that  could  be  adopted.     But,  if  it  could  not  be 
found,  again  averages  could  be  used.     I  make  this  merely 
as  a  suggestion;  I  cannot  consider  it  further  for  lack  of  time. 
Now,  when  we  have  the  installation  cost,  we  face  the  ques- 
tion of  policy  whether  to  deduct  from  the  gross  valuation  for 
depreciation,  on  account  of  wear  and  tear  of  the  property  in 
service?    The  answer  should  again  be  based  on  broad  social 
considerations,  and,  it  seems  to  me,  should  not  be  compUcated 
with  the  special  question  whether  provision  in  operating 
expenses  had  been  made  by  the  company  in  the  past  for 
depreciation,  or  with  other  such  technical  considerations 
which  Mr.  Allison  brought  out  in  his  discussion.     What  is 
the  reasonable  general  rule  to  apply?    That  is  the  question; 
let  us  forget  what  individual  companies  did  or  did  not  do. 
Whether  a  particular  concern  included  depreciation  charges 
among  op)erating  expenses  in  the  past  and  set  up  a  projjer 
depreciation  reserve,  it  seems  to  me  is  merely  an  incidental 
matter,  having  nothing  to  do  with  the  advisabiUty  of  whether 
we  should  take  account  of  the  physical  state  of  plant  in 
making  a  present  appraisal.     Certainly  in  very  few  cases 
did  past  provision  for  depreciation  have  any  connection  with 
the  profitableness  of  the  business, — with  the  abiUty  to  make 
the  provision.     Only  in  an  exceptional  case  were  adequate 
depreciation  charges  made,  whatever  the  profitableness  of 
the  undertaking.     The  average  company  woidd  probably 
have  been  able  to  make  the  charges  and  still  pay  a  reasonable 
return    on    actual    investment, — ^but    they    neglected    the 


matter,  and  either  paid  out  unduly  large  profits  or  put  the 
excess  earnings  into  the  property.  If  the  former,  then 
where  is  the  clear  demand  of  justice  not  to  make  a  deduction 
for  present  depreciation?  If  the  latter,  then,  clearly,  the 
amount  of  property  shown  by  the  appraisal  will  be  so  much 
greater  because  of  the  reinvestment  of  earnings,  and  again 
where  is  the  requirement  of  justice  for  not  deducting  from 
the  valuation  the  existing  depreciation? 

So  much  briefly  for  mere  technical  considerations.  We 
must  remember  all  the  time,  that  in  the  past  we  have  allowed 
the  companies  to  charge  such  rates  as  they  could  and  to 
make  all  the  profits  they  could,  without  regard  to  cost  or 
sacrifice  on  the  part  of  investors.  But  all  the  time  we  had 
a  right  to  restrict  the  return  to  a  fair  rate  on  actual  invest- 
ment. For  the  future  we  wish  to  regulate,  and  to  do  so  as 
definitely  as  possible.  Now,  what  is  fair  in  the  matter? 
Certainly,  we  may  reasonably  suppose  that  without  restric- 
tions on  rates  in  the  past,  the  average  company  was  able 
to  earn  a  fair  return  on  actual  sacrifice,  and  make  full 
provision  for  maintenance  of  property,  including  depreciation. 
If  so,  then  are  we  not  justified  to  disregard  any  further 
considerations  of  past  sacrifice  and  return,  or  the  question 
whether  actual  depreciation  charges  had  been  made  and  a 
reserve  set  up?  And  in  making  a  physical  appraisal,  should 
we  not  make  reasonable  adjustments  for  the  present  physical 
state  of  the  property? 

That  we  should  make  an  adjustment  in  the  appraisal  on 
account  of  depreciation  thus  seems  to  me  beyond  question, 
but  it  is  a  question  of  policy  to  be  properly  determined 
by  legislative  enactment.  If  we  should  not  provide  for  the 
adjustment,  the  chief  difficulty  would  be,  the  valuation 
in  any  case  might  be  greatly  inflated  by  the  inclusion  of 
obsolete,  old,  wornout  property,  or  more  correctly,  junk. 
Where  would  you  draw  the  line  between  property  in  service 
and  property  retired?  Would  you,  for  example,  allow  the 
Third  Avenue  Railway  Company  in  New  York  City  to 
include  its  horse  cars  at  installation  cost?  The  cars  are  still 
in  use:  they  cost  possibly  $5,000  each.  What  is  reasonable? 
If  we  make  allowance  for  depreciation,  then  it  would  not 
matter  in  any  case  what  was  included  in  the  inventory; 
if  junk  was  added  i^  the  primary  valuation,  it  would  again  be 
fully  deducted  on  account  of  accrued  depreciation. 

Everything  considered,  then,  the  reasonable  thing  to  do, 
it  seems  to  me,  would  be  to  take  installation  cost  as  the  basis 
of  valuing  existing  properties,  with  deduction  for  depreciation. 
For  future  investments,  the  money  actually  put  into  the 
business  through  the  issue  of  securities  would  probably 
furnish  the  best  basis.  In  conclusion,  let  me  suggest  again: 
what  we  should  work  for  is  definite  control  for  the  future,  so 
that  investors  will  get  a  definite  return  and  no  more  upon  a 
fixed  valuation, — so  that  regulation  may  be  determined 
chiefly  through  accounting  control  of  the  companies.  Def- 
initeness  for  the  future  is  the  thing  that  I  should  emphasize 
above  everything  else.  The  particular  basis  of  valuation 
shoidd  be  determined  according  to  the  reasonable  require- 
ments of  the  future. 


DEPRECIATION 


131 


MAKING  DEPRECIATION  DISCUSSION  UNDERSTOOD 

By  Habry  Barker 

Editor,  Engineering  News 


So  many  meanings  of  the  term  "depreciation"  have 
sprung  up,  as  Mr.  Stearns  has  pointed  out,  that  most  dis- 
cussions of  depreciation  get  all  tangled  up  in  a  maze  of 
misunderstandings.  If  we  could  only  standardize  our 
nomenclature  of  discussion  and  agree  on  certain  restrictions 
in  the  use  of  words,  a  great  step  would  be  taken.  We  could 
all  understand  what  each  was  talking  about  and  we  could 
know  that  we  were  focusing  our  attention  on  identical  ideas. 

In  my  work  I  have  found  it  convenient  to  group  the 
several  meanings  given  to  the  term  "depreciation"  into  two 
general  classes:  (a)  Losses  in  value  of  physical  property, 
and  (b)  sums  secured  from  earnings  to  offset  loss  in  value 
of  property. 

The  first  group  of  definitions  is  split  into:  (1)  aggregate 
actual  or  estimated  loss  in  value  from  all  causes;  (2)  loss 
in  value  due  to  wear-  and  age-deterioration  as  distinguished 
from  the  loss  of  value  from  liability  of  obsoletion  or  inade- 
quacy; (3)  the  loss  in  value  due  to  loss  of  ability  to  render 
full  service  or  due  to  decreased  efficiency. 

The  second  group  of  deiinitions  was  found  to  cover:  (4) 
an  annual  accounting  figure  representing  the  depreciation  for 
the  year,  or  any  other  given  period,  deducted  from  gross 
earnings  in  computing  probable  true  net  earnings;  (5)  an 
annual  sum  used  in  making  up  the  amount  of  necessary 
income  to  be  secured  by  the  rates.  This  last  is  often  an 
annuity  to  be  set  aside  out  of  earnings  to  help  create  a  reserve 
which  will  equal  the  cost  of  the  several  items  of  plant  when 
they  are  retired  from  service,  and  which  will  pay  for  the 
renewals  to  the  extent  of  the  cost  of  the  items  retired.  It 
might  well  be  instead  a  direct  repayment,  out  of  earnings, 
of  investment  equal  to  the  annual  loss  in  value  of  property 
due  to  depreciation.  There  is  a  final  observable  definition 
of  "depreciation"  as  (6)  various  aggregates  of  the  annual 
sums  secured  from  time  to  time  to  compensate  for  loss  in 
value  through  depreciation. 

The  multiplicity  of  ideas  thus  hinging  on  the  one  word 
"depreciation"  explains  the  extreme  confusion  which  has 
arisen  and  shows  the  need  of  reform.  Language  is  not 
so  impoverished  that  it  is  necessary  to  use  an  important 
technical  word  in  so  many  senses. 

The  first  detailed  definition  noted — as  the  aggregate  loss 
in  value  from  wear-deterioration,  inadequacy,  supercession, 
antiquation,  delapidation,  etc. — is  probably  the  most  used 
and  the  original  one.  This  can  well  be  adhered  to  and  a  few 
available  terms  employed  to  carry  the  other  ideas.     The 


second  detailed  definition  makes  a  most  useful  distinction, 
the  idea  of  which  should  be  preserved.  But  the  idea  is  more 
definitely  indicated  by  "wear-deterioration,"  "age-deteriora- 
tion," or  "wear-  and  age-deterioration"  according  to  the 
shade  of  meaning  desired. 

The  third  definition — ^loss  in  value  due  to  diminished 
power  to  function  or  due  to  decreased  efiiciency — ^has  no  real 
place  in  depreciation  discussions — for  mere  abUity  to  render 
the  original  service  does  not  indicate  lack  of  depreciation 
(definition  No.  1)  and  percentage  of  service  ability  (which 
is  not  the  "serviceability"  of  the  dictionary)  does  not  measure 
value.  (It  indicates  relative  value  only  when  the  duration  of 
that  percentage  of  service  ability  or  efficiency  is  considered: 
If  one  machine  can  yield  the  same  service  for  10  years  and 
a  second  machine  can  yield  the  same  service  for  20  years 
their  values  are  not  the  same.)  Instead  of  speaking  of  this 
loss  of  service  ability  as  "depreciation,"  it  would  be  better 
to  call  it  "service-ability  drop"  or  something  else.  If  there 
were  not  so  many  definitions  in  the  field  needing  weeding  out, 
this  abbreviation  to  "depreciation"  would  be  excusable;  but 
because  of  the  confusion  induced  the  longer  phrase  should  be 
reverted  to.  Similarly  in  the  case  of  the  fourth  definition, 
it  is  advisable  to  say  "depreciation  allowance"  for,  between 
speed  of  speech  and  accuracy  of  expression,  there  should  be 
no  question  of  choice. 

Definition  five  conveniently  reduces  to  "retirement  allow- 
ance"; and  for  further  simplicity  I  have  coined  the  term 
"retirance"  which  has  been  found  quite  understandable  and 
extremely  convenient. 

The  first  and  fifth  definitions  are,  perhaps,  the  ones  most 
used,  so  that  it  would  be  a  great  advance  to  agree  to  speak  of 
"depreciation"  as  the  actual  lost  value  and  "retirance"  as 
one  year's  part  of  the  compensation.  Therefore,  retirance  is 
a  definite  factor  in  rates  and  is  in  nature  a  repayment  of 
invested  capital.  "Unit-retirance"  may  be  spoken  of  as  a 
subdivision  of  retirance  as  it  has  been  apportioned  over  rates. 
"Aggregate-retirance"  is  obvious.  "Wear-retirance,"  "age- 
retirance,"  "obsoletion-retirance,"etc.,  become  useful  special 
terms  which  can  be  accurately  employed. 

By  imposing  on  ourselves  such  a  restriction  in  the  employ- 
ment of  the  terms  depreciation,  wear-deterioration,  deprecia- 
tion-allowance, retirance,  etc.,  discussion  is  not  appreciably 
encumbered  and  a  fundamental  cause  of  exasperating 
confusion  is  removed. 


132 


THE      UTILITIES      MAGAZINE 


OPEN  DISCUSSION 


Allyn  a.  Young,  Professor  of  Economics,  Cornell  Uni- 
versity: 

It  seems  to  me  that  the  question  is  not  a  question  of 
accounting;  it  is  not  a  question,  even,  of  engineering:  it  is  a 
question  of  fact,  and  primarily  of  economic  fact.  I  do  not 
agree  with  Mr.  Allison  in  his  use  of  the  term  "theoretical 
depreciation"  as  a  synonym  for  accrued  depreciation.  I 
beheve  that  accrued  depreciation  is  real  depreciation.  A 
utility  whose  plant  is  on  the  aggregate  half  wornout  or  one 
third  wornout  is  not  the  same  thing  as  a  utihty  whose  plant 
is  entirely  new. 

I  believe  that  a  new  utility  is  worth  more  in  the  market 
for  purchase  than  a  utility  that  is  partly  wornout.  I  think 
that  it  is  worth  more  in  condemnation  proceedings  than  a 
utility  which  is  partly  wornout.  And  this  brings  me  to  a 
consideration  of  one  point  advanced  by  my  friend  Dr.  Bauer. 
In  the  case  of  valuation  for  a  condemnation  sale,  we  may 
properly  assiune  that  the  proprietors  of  utilities  have  known, 
in  a  general  way,  what  the  rules  of  the  game  were.  They 
have  been  informed  by  court  decisions  and  by  established 
practice  that  plants  bought  under  condemnation  sale  are 
usually  bought  at  their  estimated  market  value;  and,  gener- 
ally speaking,  that  means  a  depreciated  physical  value. 

I  believe  the  risk  of  a  possible  forced  sale  to  the  pubUc 
at  a  depreciated  value  is  one  of  the  real  risks  which  a  pubhc 
plant  encounters.  It  may,  for  example,  be  one  of  the  things 
to  be  taken  into  account  in  the  quality  and  price  of  the 
service.  I  am  not  so  sure  about  the  matter  of  depreciation 
by  regulation. 

It  makes  no  difference  what  valuation  you  take  for  the 
future  if  we  give  a  fair  return  upon  that  valuation  and 
require  an  actual  investment — sufficiently  large  to  support 
that  valuation;  but  this  does  not  necessarily  mean  that  in  so 
doing  we  have  to  break  sharply  with  the  past  and,  whether 
we  do  justice  or  injustice  in  particular  cases,  to  insist  upon 
retroactively  enforcing  the  same  rules  that  we  are  making 
for  the  future.  I  see  no  particular  concrete  difficulty  in  the 
way  of  requiring  any  plant,  from  this  time  on,  to  keep  all 
adequate  depreciation  charges  on  whatever  basis  we  please; 
while  at  the  same  time  admitting  that  since  it  has  not  kept 
such  charges  in  the  past,  and  since  as  from  the  point  of  view 
of  its  owners,  and  from  the  point  of  view  of  the  utility  world 
and  the  business  world  in  general,  as  well  as  from  the  points 
of  view  of  law  and  of  past  accounting  practice,  such  charges 
have  not  been  considered  necessary,  we  have  no  right  to 
assume  that  its  past  practice  should  have  been  like  our 
requirements  for  the  future. 

Now,  to  depreciate  a  property  on  account  of  accrued 
depreciation  in  the  valuation  for  regulation,  for  rate-control, 
is  to  assume,  of  course,  that  the  company  should  have 
accumulated  a  reserve  on  account  of  accrued  depreciation. 
We  know  perfectly  well  that  such  was  not  ordinary  business 
practice  in  the  case  of  companies  with  large  investments. 
We  know  perfectly  well  that  such  companies  could  see  no 
reason  why  they  should  attempt  to  maintain  what  I  should 


call  the  market  value  of  their  capital  intact,  by  depreciation 
charges.  We  also  know  that  it  is  and  has  been  considered 
entirely  adequate  business  practice  to  set  aside  such  allow- 
ances for  depreciation  as  would  adequately  provide  for 
replacement. 

I  agree  entirely  with  Mr.  Erickson's  paper,  so  far  as  it 
touches  the  treatment  of  the  accrued  depreciation  of  railroad 
properties.  I  beheve  that  that  matter  has  been  adequately 
taken  care  of  in  the  past  by  most  railroads — not  on  all — by 
charges  to  operating  expenses  on  account  of  maintenance. 
But  I  am  inclined  to  think  that  there  is  a  somewhat  larger 
likeness  than  Mr.  Erickson  seemed  to  imply  between  railroads 
and  other  public  service  companies  with  large  and  varied 
properties.  I  have  never  quite  understood  the  logic  of  the 
rule  of  the  Wisconsin  Commission  that  accrued  depreciation 
must  be  charged  in  order  properly  to  provide  for  replacement, 
coupled,  as  it  was,  with  the  actual  enforcement  in  practice 
of  a  rule  that  the  depreciation  charges  should  be  much  more 
than  adequate  to  provide  for  replacement,  and  that  by  the 
whole  amount  of  that  permanent  reserve  of  which  Mr. 
Erickson  has  spoken.  In  general,  then,  although  I  do  not 
agree  with  my  friend  Allison's  use  of  the  phrase  "theoretical 
depreciation,"  I  am  inclined  to  agree  with  his  general  con- 
clusions. 

Robert  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 
versity: 

I  want  to  enlarge  on  the  point  brought  out  by  Dr.  Bauer. 
I  think  he  is  quite  right  in  saying  we 'must  draw  a  curtain 
between  the  past  and  the  future.  I  think  we  need  a  little 
more  definite  statement  of  just  what  we  will  do  in  the  future. 

It  seems  to  me  what  you  have  to  do  is  to  serve  notice  now 
that  any  excessive  returns  between  now  and  the  next  time 
we  regulate  any  company,  shall  be  deducted  from  the  valua- 
tion, unless  they  are  reinvested  in  the  plant,  in  which  case 
the  valuation  should  remain  as  before.  The  extra  invest- 
ment would  then  doubtless  lessen  the  Of)erating  cost,  and 
the  company  would  have  to  reduce  the  rate  in  order  to  avoid 
a  continuance  of  the  excessive  return  with  its  accompanying 
deduction  from  valuation.  Each  deduction  from  valuation 
would  obviously  lessen  the  amount  the  consumers  must 
contribute  towards  fair  return.  If  instead  of  reducing  its 
rate  it  continued  earning  excess  returns  between  now  and 
1920  and  declared  them  out  as  dividends,  it  seems  entirely 
proper  that  they  shoidd  continue  to  be  deducted  even 
though  the  result  in  1920  was  such  that  there  is  no  longer 
any  valuation  left.  If  the  valuation  was  thus  reduced  by 
1920  not  merely  to  zero  but  to  a  minus  quantity  (say  $10,000) 
then  it  simply  indicates  that  the  public  has  paid  the  company 
not  only  the  entire  expense  of  its  plant  but  $10,000  additional; 
instead  of  the  public  owing  the  company  anything  on  its 
investment,  the  company  now  owes  the  public  a  fair  return 
on  $10,000.  This  should  be  collected  from  the  stockholders. 
With  publicity  of  accounts,  the  stockholders  coidd  have 
known  that  their  excess  dividends  were  repayments  of  their 


DEPRECIATION 


133 


investment  and  more,  and  would  have  no  excuse  for  being 
unprepared  to  meet  their  debt  to  the  public. 

This  all  presupposes  that  you  announce  definitely  now 
what  shall  constitute  a  fair  return  in  the  future.  The  basis 
for  any  such  return  should  be  the  actual  future  investment, 
plus  some  arbitrary  figure  representing  the  investment  of 
each  company  existing  at  the  time  the  statute  is  passed  which 
announces  the  future  policy— and  it  will  require  a  statute. 
The  arbitrary  amount  fixed  for  existing  companies  cannot 
be  entirely  satisfactory  to  all;  for  some  compromise  may  be 
necessary  by  reason  of  the  confused  situation  referred  to  by 
Mr.  Bauer.  But  if  we  do  the  best  we  can  with  the  past, 
then  start  out  with  an  actual  cost  basis  for  the  future,  we 
shall  read  fairly  satisfactory  results.  But  to  prevent  the 
future  from  developing  into  another  confused  past  before 
we  get  around  to  regulating  a  company  again,  it  will  be 
necessary  to  hold  it  strictly  accountable  to  the  public  for  any 
excess  profits  earned  in  the  meantime. 

A.  M.  Sakolski,  Secretary  Valuation  Committee,  The  Dela- 
ware and  Hudson  Company,  Albany,  N.  Y.: 

Mr.  Bauer  would  limit  profits,  future  profits,  as  he  says, 
to  a  reasonable  return:  has  he  any  scheme  for  preventing 
losses  to  investors  on  the  same  grounds?  Now,  if  you  have 
a  limit,  upward,  doesn't  it  logically  follow  that  you  should 
place  a  limit  in  the  opposite  direction  and  guarantee  investors 
who  take  the  greatest  risks  against  losses  or  complete  losses? 
Is  it  not  a  principle  of  agency  that  as  long  as  the  agent  is 
limited  in  the  amount  of  his  compensation,  he  is  also  to  be 
recouped  for  his  losses  incurred  in  his  capacity  as  agent? 
Has  Mr.  Bauer  any  scheme  to  recoup  all  investors,  both 
bond  and  stockholders,  in  public  utilities  for  unusual  losses? 

It  is  true  that  a  class  of  investors,  viz.:  bondholders  and 
preferred  stockholders  are  generally  limited  to  a  fixed  rate 
of  return,  but  as  an  offset  they  demand  special  preference 
both  as  to  security  and  as  to  the  distribution  of  earnings. 
But  no  sane  person  would  think  of  financing  a  public  utility 
by  bond  issues  alone;  and  if  you  issue  ordinary  stock,  I  mean 
common  stock,  and  limit  the  rate  of  retiu:n  thereon,  such  a 
rate  would  be  so  much  above  the  ordinary  rate  expected  by 
the  largest  class  of  investors,  that  Mr.  Bauer's  scheme,  would 
have  little,  if  any  practical  effect. 

Professor  Bauer: 

My  answer  is  twofold.  (1)  If  the  investment  is  reasonably 
conceived  and  properly  managed,  the  stipulated  return 
could  usually  be  earned.  (2)  But,  as  to  future  investment, 
if  the  policy  followed  is  clearly  determined,  the  risk  involved 
would  be  taken  into  consideration  in  the  rate  of  return  upon 
which  securities  may  be  issued.  If  it  is  clearly  known  that 
the  company  may  pay  a  given  return  to  investors  and  no 
more,  but  that  the  business  must  earn  the  amount,  then 
clearly  the  interest  or  dividend  basis  on  which  bonds  or 
stocks  can  be  issued  will  be  at  a  higher  rate  than  if  an  absolute 
guarantee  were  given  that  the  stated  return  will  be  paid, 
supported  by  the  taxing  power  of  the  community.  I  am 
not  certain  but  that  an  absolute  guarantee  would  furnish 
the  wiser  policy.     But  so  long  as  the  investors  know  what 


the  policy  is,  there  can  be  no  injustice.  It  is  clearness  and 
definiteness  that  I  have  been  urging.  As  to  Mr.  Hale's 
suggestion,  that  periodically  the  investment  figures  might 
be  revised  to  take  account  of  excess  earnings,  it  seems  to 
me  that  would  be  an  unworkable  scheme.  The  return 
should  be  restricted  each  year  to  a  definite  return  on  the  then 
existing  investment.  The  machinery  to  effect  such  control 
could  be  easily  provided. 

Morton  G.  Lloyd,  Technical  Editor,  Electrical  Review 
and  Western  Electrician,  Chicago: 

The  point  involved  in  the  last  question,  and  also  the 
proposal  of  Mr.  Hale,  not  only  can  be  carried  out,  but  are 
being  carried  out  already,  under  the  traction  ordinances  of 
two  of  our  American  cities.  In  Kansas  City,  Mo.,  under  the 
ordinance  adopted  July  7,  1914,  the  return  to  stockholders 
is  limited  to  6  per  cent  until  the  excess  above  that  amount  has 
been  used  to  amortize  all  of  the  intangible  elements  in  the 
valuation.  Under  the  scheme  in  operation  in  Cleveland, 
Ohio,  all  returns  in  excess  of  6  per  cent  on  an  agreed  valuation 
are  put  in  a  reserve  fund,  and  when  this  exceeds  a  stipulated 
amount,  a  reduction  in  fare  is  made.  If  the  reserve  becomes 
reduced  below  a  stipulated  minimum,  an  increase  in  fare 
goes  into  effect. 

Oscar  F.  Gayton,  Valuation  Supervisor,  Department  of 
Public  Service,  Chicago,  III.: 

I  think,  in  Professor  Hale's  arrangement,  that  he  would 
produce  a  very  poor  class  of  managers,  and  from  such 
a  point  of  view  his  paternal  scheme  is  in  error  because  any 
scheme  that  does  not  provide  for  the  rewarding  of  efficiency  is 
fundamentally  wrong. 

In  regard  to  the  classes  of  depreciation  cited  by  Mr.  Goetz, 
the  reason  for  allowing  a  greater  percentage  of  depreciation 
in  profit  and  loss  accounts  than  one  does  in  valuation  cases, 
is  because,  in  the  valuation  cases,  you  are  dealing  with  some- 
thing that  is  past,  something  that  is  real  and  concise;  and  in 
the  accounts  you  are  dealing  with  the  future,  and  you  have 
to  allow  a  great  deal  for  contingent  depreciation.  In 
waterworks  property  valuation  the  annual  allowance  of 
depreciation  on  the  plant  taken  as  a  whole  is  never  more 
than  a  fraction  of  1  per  cent,  probably  about  six  tenths; 
whereas,  in  accounting,  in  providing  for  the  future,  it  is 
always  customary  to  allow  1  per  cent,  to  include  the  various 
phases  of  depreciation,  physical,  functional  and  contingent. 

In  regard  to  Mr.  Allison's  remarks,  I  believe  that  his 
replacement  fund  is  the  same  thing  as  a  depreciation  fund, 
that  it  is  allowed  for  in  the  same  manner  and  amounts  to 
the  same  thing. 

L.  K.  Frank,  Accountant,  N.  Y.  Telephone  Co.,  New  York 
City: 

I  would  like  to  point  out  that  the  depreciation  reserve  is  an 
economic  concept  and  that  the  depreciation  reserve  is 
required  to  protect  the  integrity  of  the  capital  investment. 
If  a  utility  is  permitted  to  pay  dividends  only  to  the  extent 
of  a  fair  return  on  the  capital  invested,  a  depreciation  reserve 
must  be  provided  which  will  insure  the  replacement  of  the 


134 


THE      UTILITIES      MAGAZINE 


capital  consumed  in  the  business,  since  investors  must  have 
their  capital  returned  to  them  in  the  form  of  higher  dividends 
or  else  replaced  through  a  depreciation  reserve. 

In  cases  where  no  reserve  has  been  provided,  utilities  have 
gone  into  bankruptcy  or  out  of  business  or  rates  have  been 
made  unduly  burdensome  to  provide  for  past  neglect  regard- 
ing depreciation  reserve. 

Furthermore,  I  would  like  to  emphasize  the  fact  that  the 
depreciation  reserve  is  for  the  replacement  of  capital,  not 
of  plant.  That  is,  the  reserve  should  be  accrued  so  that 
when  $100  of  plant  goes  out  of  service,  there  will  be  $100 
in  the  reserve  to  replace  that  capital.  If  the  cost  of  replacing 
the  plant,  which  originally  cost  $100,  is  now  $150,  the 
additional  $50  represents  new  capital  investment  to  be 
obtained  from  stockholders.  If  this  is  not  done,  the  sub- 
scribers or  users  of  the  public  utilities  are  made  to  contribute 
$50  as  an  outright  gift  to  the  stockholders. 

The  railroads  have  proceeded  on  the  theory  that  the  users 
pay  for  the  replacement  of  plant  instead  of  capital  and 
many  engineers  are  in  favor  of  it;  but  from  an  economic 
standpoint  it  must  be  recognized  that  the  depreciation 
reserve  is  for  the  replacement  of  capital  and  not  for  the 
replacement  of  plant. 

By  recognizing  the  economic  character  of  the  depreciation 
reserve  and  following  these  principles,  two  objects  are 
attained:  first,  the  cost  of  replacing  the  capital  consumed 
in  the  business  is  spread  over  past,  present  and  futiu"e  users 
and  included  in  the  operating  costs;  and  secondly,  the 
obligation  to  continue  the  business  is  divided  equitably 
between  the  stockholders  and  the  users,  both  of  whom  must 
be  made  to  meet  their  obligations  by  regulation. 

Frank  E.  Seidman,  Accountant,  Public  Service  Commis- 
sion, Neic  York: 

It  seems  to  me  that  there  is  one  point  that  Dr.  Bauer 
ought  to  bring  out  in  connection  with  the  future  policy  he 
has  outlined,  as  to  deductions  for  depreciation.  As  I  under- 
stand Dr.  Bauer's  theory,  he  advocates  for  the  future 
an  allowance  of  a  return  on  the  actual  dollars  put  into 
the  business  by  the  investors.  He  did  not  say,  however, 
whether  or  not  he  would  deduct  from  this  investment  the 
amounts  contributed  by  consumers  on  account  of  deprecia- 
tion. I  would  heartily  endorse  Dr.  Bauer's  method  if  it 
were  qualified  to  the  extent  that  the  amount  of  depreciation 
contributed  by  the  consumers  be  deducted  from  original 
investment.  If  this  contribution  for  depreciation  is  rein- 
vested in  the  property  used  for  the  service,  then  of  coiu-se 
the  company  is  entitled  to  a  return  upon  that  reinvestment. 
The  amounts  so  reinvested  should,  however,  be  added  to 
the  original  investment,  and  from  this  total  the  amount  con- 
tributed by  the  consumer  for  depreciation  should  be  deducted. 
If,  on  the  other  hand,  instead  of  this  money  being  reinvested 
in  operating  property,  it  be  kept  in  a  fund  drawing  interest, 
or  put  into  non-operating  ventures,  such  as  outside  invest- 
ments, one  of  two  methods  coidd  be  used  in  connection  with 
the  question  of  depreciation.  Either  the  amount  of  de- 
preciation so  contributed  shoidd  be  deducted  from  the  original 
dollars  put  in  by  the  investors,  or  the  earnings  of  the  invest- 


ments made  from  this  contribution  should  be  treated  as  an 
operating  income.  Either  of  these  methods  should  give  the 
desired  result,  i.  e.,  an  allowance  to  the  consumer  on  account 
of  his  contribution.  As  an  accountant,  I  should  prefer  to 
deduct  the  consumer's  contribution  from  original  investment 
rather  than  treat  the  income  therefrom  as  an  operating  one. 
The  inclusion  of  non-operating  income  under  operating  reven- 
ues is  not  very  consistent  accounting,  and  woidd  be  generally 
criticized.  It  seems,  therefore,  that  the  best  method  would 
be  to  deduct  the  depreciation  contributed  by  the  consumer 
from  original  investment  and  allow  a  retm-n  upon  the  balance. 

Professor  Young:' 

The  question  is  asked  whether  valuation  for  sale  may 
properly  be  fixed  at  a  lower  total  amount  or  sum  than 
valuation  for  rate  control.  What  are  we  to  do,  for  example, 
in  the  regulation  of  a  company  that  purchased  its  plant  from 
another  company  at  your  lower  valuation,  if  such  invest- 
ment yields  more  than  an  adequate  return?  I  should  say, 
in  the  first  place,  that  we  cannot  assume  a  voluntary  sale 
of  the  plant  for  less  than  its  market  value,  as  measured  by 
capitalized  earnings  (not  as  measured  by  either  its  depre- 
ciated or  undepreciated  physical  property),  and,  in  the 
second  place,  in  the  case  of  sale  to  the  city,  a  number  of 
questions  are  raised  with  which  neither  the  question  nor  my 
former  statement  have  anything  to  do. 

Dean  Langmuir,  Statistician,  Public  Service  Commission, 
First  District,  New  York  City: 

I  have  just  one  word  to  say  about  Mr.  Allison's  remarks. 
Mr.  Allison  has  said  that  we  should  not  go  back  to  the  past 
to  revise  earnings.  Surely,  allowances  for  going  value  on 
the  basis  of  early  deficits  constitute  a  distinct  revision  of 
past  history.  I  would  like  to  know  if  Mx.  Allison  is  as 
strongly  opposed  to  such  allowances  as  he  is  to  taking  de- 
preciation into  account? 

James  E.  Allison,  Consulting  Engineer,  St.  Louis,  Mo.: 

I  will  say  that  I  am  strongly  opposed  to  the  so-called 
Antigo  theory,  which  deducts  for  all  excess  profits  in  the  past 
and  adds  for  all  deficits.     I  don't  think  it  is  practicable. 

So  far  as  taking  account  of  deficits  in  making  up  so-called 
"going  value,"  I  believe  that  deficits  over  a  certain  initial 
period  of  the  enterprise  should  be  capitaUzed. 

We  have,  in  the  starting  of  any  new  enterprise,  a  predeter- 
mined deprivation  of  income;  the  investor  knows  it;  but  he 
goes  in  nevertheless,  expecting  to  have  that  deprivation  of 
income  made  up  to  him  in  capitalization,  which  he  hopes  in 
the  future  will  pay  returns.  He  is  entitled  to  this  and  also 
to  a  capitalization  of  his  initial  risk.  Now  how  long  a  time 
this  initial  period  ought  to  cover  depends  on  the  particidar 
enterprise.  It  is  a  hard  thing  to  decide  and  impossible  of 
discussion  in  the  short  time  allowed  here. 

1  Someone  in  the  audience  whose  name  the  reporter  did  not  get  asked 
Professor  Young  whether  he  would  base  rates  on  a  different  figure  from 
the  sale  value;  and  whether  he  would  sell  his  plant  for  a  figure  to  some- 
body and  that  person  could  get  a  bigger  return  on  it  than  a  fair  return. 


DEPRECIATION 


135 


Professor  Young: 

One  or  two  speakers  who  followed  me  in  the  five-minute 
discussion  raised  the  question  whether  depreciation  for 
replacement  is  not  the  same  sort  of  thing  as  the  depreciation 
that  we  are  talking  about  when  we  speak  of  accrued  depre- 
ciation. Whether  that  is  true  or  not  depends  entirely  on 
the  nature  or  size  of  the  business.  There  are  some  busi- 
nesses where  some  particularly  large  wasting  assets  may  be 
especially  important:  in  such  cases  charges  must  be  made 
for  accrued  depreciation.  Where  we  have  large  properties, 
with  items  of  plant  going  out  of  service  and  going  into  ser- 
vice, year  after  year,  then  it  seems  to  me  that  depreciation 
for  replacement  is  a  very  different  thing  than  the  kind  of 
depreciation  which  we  have  in  mind  when  we  speak  of  "total 
accrued  depreciation";  and  in  general  it  would  require  very 
much  smaller  depreciation  charges. 

The  difference  is  fundamental.  I  admit  that  all  proper 
provision  should  have  been  made  for  adequate  replacement 
from  the  beginning  by  all  public  service  companies.  I 
think  we  should  hold  them  up  to  that  standard.  But  I  don't 
think  that  we  shoidd  usually  assume  that  (before  regidation) 
they  should  have  provided  in  a  similarly  adequate  fashion 
for  depreciation  in  market  value,  or  depreciation  in  what  one 
speaker  this  morning  called  "  capital, "  which  is  really  what 
we  have  in  mind  when  we  are  discussing  the  matter  of  accrued 
depreciation. 

Harry  Barker,  Edilor  of  Engineering  News: 
In  no  part  of  all  public  utility  discussions  are  sound 
doctrines  more  needed  than  in  treating  of  depreciation — and 
nowhere  are  more  misapprehensions  visible.  Even  Mr. 
Erickson  seems  to  harbor  one  peculiar  and  disturbing 
illusion,  though  the  final  results  secured  by  him  and  by  the 
Wisconsin  Commission  are  equitable. 

In  his  paper  Mr.  Erickson  makes  these  remarks : 

"Much  has  been  said  about  the  relative  merits  of  the 
straight  line  and  sinking  fund  method  of  providing  for 
depreciation.  Without  going  into  details  in  this  matter  it 
can  be  said  that  the  sinking  fund  method  implies  a  more 
efficient  use  of  the  reserves.  It  also  means  that  because  of 
such  use  the  amounts  the  customers  will  have  to  contribute 
to  cover  depreciation  is  less  than  under  the  straight  line 
method.  The  inference  that  can  be  drawn  from  these  facts 
is  that  the  sinking  fund  method  is  the  most  economical 
and  hence  would  also  seem  to  be  the  best  of  the  two  methods 
from  the  point  of  view  of  public  interests." 

"In  cases  where  the  utilities  have  properly  provided  for 
depreciation,  and  where  the  amounts  so  provided  have  been 
used  for  necessary  and  proper  renewals  and  for  the  accumu- 
lation of  a  reserve  for  the  purpose  of  covering  the  accrued 
but  unmatured  depreciation  of  the  property  still  in  use,  no 
reduction  from  the  cost  new,  because  of  depreciation,  should 
be  made  in  determining  the  fair  value  for  rate  making  and 
certain  other  purposes." 

Herein,  it  seems  to  some  of  us,  lies  the  delusion  that 
many  still  cling  to — that  depreciation  can  be  compensated  for 
more  cheaply  by  sinking  funds  than  by  any  other  plan.  It  is 
only  the  old,  old  story  of  something  for  nothing. 

According  to  the  leading  United  States  Supreme  Court 


decision  in  this  matter  of  depreciation  compensation — ^the 
famous  Knoxville  Water  case  (City  of  Knoxville  vs.  KnoxviUe 
Water  Co.,  1909,  29  Sup.  Ct.  Rep.  148)— the  utility  company 
is  entitled  to  recover  a  sufficient  sum  above  interest,  cost 
of  operation  and  repairs,  to  make  good  the  retiring  of  property 
items  as  they  come  to  the  end  of  their  life.  It  is  entitled 
to  see  that  from  earnings  the  investment  is  kept  unimpaired. 
It  can  base  its  rates  only  upon  the  present  (depreciated) 
value  of  its  plant. 

This  embodies  the  proposition  that  for  every  dollar  by 
which  the  property  has  depreciated  the  company  is  entitled 
to  be  paid  back  a  dollar  of  its  investment — a  dollar  above 
its  interest  and  profits.  When  that  is  done  each  item  is 
completely  repaid  by  the  time  it  is  retired,  and  current 
depreciation  is  made  good  each  year.  If  this  is  not  done,  in 
the  course  of  time,  replacements,  to  a  certain  extent  at 
least,  have  to  be  made  with  entirely  new  capital  which  is 
piled  upon  the  old.  This  piling  is  an  economic  sin  against 
future  generations. 

Apparently  the  Knoxville  decision  and  the  economic 
principles  beneath  it  demand  an  immediate  full  repayment 
to  the  company  to  offset  its  losses  in  assets — rather  than 
permitting  a  deferred  payment  to  be  locked  up  in  a  sinking 
fund  until  a  machine  is  thrown  out.  The  sinking-fund 
reserve  does  not  meet  the  demands  for  depreciation  com- 
pensation. The  history  of  sinking-fund  shows  why;  sinking 
funds  were  arranged  (years  before  the  need  of  modem 
depreciation. compensation  was  felt)  to  provide  tax  fimds  for 
the  retirement  of  public  bond  issues  falling  due.  Dragging 
the  sinking  fund  into  depreciation  finance  was  a  mistake. 
Realizing  that  error,  it  is  an  even  greater  mistake  for  public 
and  utility  oflScials  still  to  cling  to  the  sinking-fund  fiction 
and  its  necessary  sequel — full  undepreciated  value  in  rate- 
basis  worth — when  every  equity  can  be  maintained  before 
the  law. 

A  word  is  needed  on  just  how  and  why  the  sinking  fund 
scheme  falls  down:  It  is  popular  to  consider  that,  with  a  given 
length  of  life  of  a  machine,  the  annual  depreciation  follows 
the  growth  of  a  sinking  fund  sufficient  to  extinguish  the  cost 
at  the  end  of  the  probable  life.  Now  it  is  well  known  that  the 
annual  contribution  is  of  such  a  size  that  it  will,  if  invested 
at  compound  interest,  with  the  interest  accumulations,  equal 
the  cost  of  the  property  item  after  a  given  term  of  years. 
The  sinking-fund-annuity  scheme,  however,  in  the  majority 
of  cases,  has  been  but  a  convenient  method  of  calculating 
a  supposedly  fair  burden  on  the  customers;  and  the  annuities 
have  been  turned  back  into  the  business. 

But  each  annuity  does  not  approximate  the  actual  incre- 
ment in  depreciation — for  this  is  equal  to  the  annuity  plus 
the  interest  on  the  accumulating  fund.  If  the  discrepancy 
in  depreciation  compensation  is  not  provided  somewhere, 
grave  inf^stice  will  be  done — for  it  is  through  the  rates,  and 
only  through  the  rates,  that  the  entire  depreciation  is  made 
good  and  the  investment  kept  unimpaired.  This  discrepancy 
between  annuity  and  needed  compensation  is  secured,  as 
Mr.  Erickson  intimates,  by  allowing  the  company  to  include 
in  rate-basis  worth  the  full  undepreciated  value  of  the 
property  although  that  value  no  longer  exists.     Part  of 


136 


THE      UTILITIES      MAGAZINE 


what  should  have  been  accounted  for  as  direct  repayment 
against  depreciation  is  recovered  as  increased  interest. 

Even  when  an  actual  reserve  fund  is  created  and  all 
annuities  and  interest  accumulations  are  properly  credited  to 
it  the  sinking-fund  scheme  is  no  cheaper.  The  accumulating 
fund  keeps  pace  with  the  depreciation  it  is  true,  but  this 
fund — property  of  the  company — is  not  free  capital.  It  is 
tied  up;  it  is  earning  only  for  its  own  aggrandizement;  it 
brings  the  company  nothing  for  operation  or  profit,  so  that 
again  full  undepreciated  value  of  plant  has  to  be  used  in 
rate-basis  worth  to  preserve  equity  and  prevent  confiscation. 

Therefore,  it  is  seen  that  the  sinking-fund  scheme,  so 
called,  is  no  cheaper  than  a  plan  that  aims  to  repay  the 
depreciation  loss  immediately  and  as  such.  The  objections 
cited  to  the  sinking-fund  scheme  of  providing  against  depreci- 
ation have  led  many  to  take  up  the  old  "straight  line"  plan 
of  apportioning  charges  uniformly  over  the  years.  Where 
the  operating  costs  go  up  appreciably  as  a  machine  deterio- 
rates, this  can  be  shown  to  reasonably  approximate  the  true 
depreciation.  But  where  fixed  charges  predominate  or 
where  operating  costs  do  not  materially  rise  because  of  age, 
the  straight  line  plan  gives  too  heavy  repayment  in  the 
early  years  and  too  light  charges  toward  the  end  of  life. 
On  this  account  various  modifications  have  been  tried;  the 
one  developed  by  Frederic  P.  Stearns  is  the  most  ingenious 
and  the  only  scientific  one — this  is  the  "equal-annual- 
payment  plan. ' '  Briefly  stated,  to  make  this  record  complete, 
each  annual  compensation  is  made  equal  to  a  hypothetical 
sinking-fund  annuity  plus  the  interest  accretion  of  a  hypo- 
thetical reserve  fund.  The  annual  compensation  is  regarded 
as  a  straight  repayment  of  lost  investment  and  the  rate- 
basis  worth  of  each  ageing  item  of  plant  is  constantly  reduced. 
The  sum  of  depreciation  compensation  and  interest  is  con- 
stant. Delusions  are  dissipated  and  the  whole  rate-making 
process  stands  on  a  lawful,  equitable  and  firm  foundation. 

Hon.  John  M.  Eshleman: 

I  did  not  intend  to  say  another  word.  This  subject  has 
always  appealed  to  me  as  being  so  simple  that,  perhaps,  in 
view  of  all  that  has  been  said,  I  am  the  one  that  is  simple. 

I  have  always  been  impressed  with  the  fact  that  we  are 
often  determined  in  our  theory  by  the  side  we  are  supposed 
to  represent.  Now,  I  mean  that;  and  I  think  it  has  resulted 
in  a  great  deal  of  confusion.  Too  many  utility  men  have 
adopted  a  certain  theory,  and  have  made  themselves  believe 
it  is  true,  because  some  great  interests  are  involved;  and 
too  many  people  on  the  other  side — ^that  is,  supposedly  on  the 
other  side,  although  I  don't  think  there  should  be  two  sides 
to  this — have  adopted  that  view  which  will  give  the  utility 


the  least.  I  don't  think  we  should  concern  ourselves  with 
the  outcome  of  any  view  we  adopt,  provided  we  are  in- 
tellectually honest  in  our  view. 

We  have  got  to  hold  out  a  future;  and  it  was  necessary 
for  us  to  hold  out,  at  any  particular  time  in  the  past,  that 
inducement  which  will  make  the  man  of  capital  invest  it  in 
the  enterprise  in  competition  with  other  available  investments. 
Isn't  that  true?  Now,  as  the  risk  becomes  greater,  the 
chance  of  reward  must  be  increased.  The  man  who  puts  his 
money  into  this  enterprise  must  know  two  things,  or  he 
won't  put  it  in.  First,  he  has  got  to  get  the  capital  back; 
and,  second,  he  has  got  to  have  something  for  the  use  of  it 
while  it  is  engaged.  Any  method  of  depreciation  must  have 
that  in  view;  and  that  is  all  there  is  to  it. 

I  am  as  satisfied  with  what  I  said  on  the  first  evening,  even, 
as  I  was  then,  that  I  was  right;  because  Dr.  Bauer  and  most 
of  the  rest  who  have  come  on  here  have  practically  taken  the 
same  view  that  I  have  on  the  general  proposition.  I  say 
that  for  the  past  the  same  rules  that  we  impose  for  the 
future,  either  on  legal  or  equitable  lines,  cannot  be  imposed; 
but  that  the  standard  which  all  desire  to  reach  for  the  past 
should  be  as  nearly  what  we  are  going  to  do  for  the  future 
as  is  possible,  under  the  legal  and  economic  limitations  that 
are  brought  about  by  the  fact  that  we  did  not  do  in  the 
past  that  which  we  could  do.  But  always  having  in  mind,  on 
this  particular  question  of  depreciation,'  this  one  thing:  that 
it  is  just  a  question  of  common  sense,  to  get  our  public  utility 
work  done  and  hold  out  that  inducement  which  wUl  lead 
the  man  of  capital  to  do  it.  When  we  have  that  in  mind, 
we  must  fulfil  the  two  considerations,  namely,  give  the 
capital  back,  and  a  return  while  it  is  being  used,  always 
having  before  us  for  comparison  what  it  would  cost  the 
public  to  do  the  work  as  the  maximum  that  in  any  event 
must  be  allowed  to  private  ownership.  And  if  we  don't  hold 
out  the  inducement  I  have  here  suggested,  public  owner- 
ship, of  course,  is  the  only  alternative;  and  if  the  man  of 
private  capital  asks  for  more,  likewise  public  ownership  is 
inevitable. 

I  would  suggest  to  the  utility  representatives  and  the  pub- 
lic that,  after  all,  we  represent  the  same  people;  and  that  we 
should  not  adopt  that  view,  that  will  bring  about  the  greatest 
return  for  that  which  we  represent.  But,  rather,  we  should 
try  to  get  through  an  absolutely,  intellectually  honest  method 
for  that  which  must  be  followed  in  order  to  get  our  utility 
work  done.  Pure  common  sense  demands  that  the  sugges- 
tions that  I  have  made  here  as  to  these  two  considerations 
can  never  be  violated;  and  it  doesn't  make  a  great  deal  of 
difference,  from  your  actual  depreciation,  if  you  have  had 
anv. 


GOING      VALUE 


137 


PART  VI— GOING  VALUE 


INTRODUCTORY  REMARKS 

By  Hon.  Morris  Schaff 

Commissioner,  Massachusetts  Board  of  Gas  and  Electric  Light  Commissioners 


GENTLEMEN:— 
It  is  an  enviable  honor  to  preside  over  a 
conference  where  men  imbued  with  a  deep 
sense  of  justice  and  devotion  to  inspiring  political 
ideals  discuss  the  fundamental  principles  of  law,  public 
policy,  business  and  fair  dealing  bfetween  man  and 
man  involved  in  the  regulation  of  public  service  cor- 
porations. Moreover,  that  honor  in  my  own  case  is 
augmented  by  a  profound  conviction  that  out  of  this 
Conference  great  good  should  and  will  come,  namely, 
clearer,  wiser,  steadier  and  more  courageous  adminis- 
tration of  the  powers  conveyed  to  our  public  service 
boards.  So  then,  gentlemen,  your  chairman  opens 
this  meeting  with  a  sense  of  future  pleasure  as  well 
as  immediate  honor.  And  let  me  say  that  the  reali- 
zation of  that  wiser,  steadier,  clearer  and  more 
courageous  administration  of  our  powers  has  been  the 
dream  of  my  life  as  a  commissioner.  And  in  this 
connection  I  trust  it  will  be  without  impropriety  if  I 
refer  to  the  fact  that  my  term  of  service  on  the  Massa- 
chusetts Board  of  Gas  and  Electric  Light  Commis- 
sioners has  been  continuous  since  1893,  longer  by  years 
than  that  of  any  other  commissioner  I  know  of. 
Meanwhile,  with  an  incomparable  fellow  laborer  and 
leader,  the  late  Forrest  E.  Barker,  some  hard,  and  I 
hope  valuable,  pioneer  work  has  been  done.  We  cer- 
tainly blazed  the  way  through  the  untraveled  wilderness 
of  the  early  days  of  regulation,  and  notwithstanding 
the  desertion  of  a  chairman  and  the  chief  clerk  to  the 
camp  of  Addicks  (and,  by  the  way,  they  never  after- 
ward came  to  the  office  without  wearing  an  abashed 
look,  a  look  such  as  I  shall  never  forget  on  the  faces 
of  officers  who,  on  the  fields  of  the  Wilderness  and 
Spottsylvania  and  elsewhere,  had  abandoned  their 
colors  while  the  enemy's  volleys  were  thundering  in 
their  and  my  ears).  Well,  amid  desertion  and  the 
always  insidious,  corrupting,  demoralizing  influences, 
social  and  political,  of  the  Addicks  school  of  exploiters 
of  gas  and  electric  properties,  we  planted,  and,  I  am 
proud  to  say,  defended  victoriously  more  than  once  the 
policy  of  Massachusetts  which,  in  a  word,  is  this : 

Ceaseless  and  resolute  protection  of  the  companies 
from  political  demagogues,  generous  allowance  to 
stockholders  upon  the  legitimate  and  authorized  capital 
of  the  undertaking,  and,  in  harmony  with  a  long, 
deliberate  and  oft-repeated  policy  of  the  great  Common- 


wealth, insistence  upon  as  low  a  capitalization  as 
circtimstances  will  permit  and  such  management  as 
will  provide  for  the  very  best  care  of  th«  plant,  anticipat- 
ing as  far  as  possible  every  call  for  more  and  better 
service;  and  finally,  and  above  all,  in  season  and  out 
of  season,  the  cultivation  of  honor  and  a  high  public 
spirit  on  the  part  of  the  directorates.  In  laying  down 
the  foundations  of  this  policy  we  adopted,  at  an  early 
day,  in  fact  in  1893,  a  single  principle  that  has  served 
as  a  torch  for  our  guidance,  namely,  that  a  consumer 
owes  four  natural  obligations  and  no  more  to  a  gas  or 
electric  light  company:  (1)  to  pay  what  the  gas  or 
electricity  costs  at  the  burner,  (2)  an  abundant  allow- 
ance for  wear  and  tear  on  the  property,  (3)  fair,  and,  in 
case  of  manifest  zeal  and  ability,  a  generous  dividend 
on  the  money  that  has  come  out  of  the  stockholder's 
pocket  to  build  and  equip  the  plant,  and  (4)  in  addition 
such  a  sum  as  will  provide  the  management  with 
ample  funds  to  meet  uncontrollable  contingencies. 
When  he  discharges  these  obligations  he  has  discharged 
all  he  owes,  and,  if  the  company  be  managed  with 
honor,  the  money  he  pays  in  for  depreciation  and  con- 
tingencies meanwhile  will  not  be  paid  out  on  watered 
capital  or  on  extravagant  salaries.  When  such  a  policy 
is  conservatively  pursued,  there  is  bound  to  be  a 
surplus,  which,  if  invested  in  the  plant,  is  equally 
bound  to  secure  to  the  consumer  the  lowest  possible 
prices  and  for  the  investor  the  safest  and  highest 
possible  returns. 

It  is  easy  to  see  that  where  this  policy  of  capitalization 
and  broad-minded  regulation  is  carried  out  in  good 
faith  that  the  questions  of  reproductive  values,  per- 
centages for  depreciation,  capitalization  of  franchises, 
going  values  and  overhead  charges  are  not  likely  to 
arise.  We  have  had  but  one  case  where  they  were 
raised,  the  Haverhill  Gas  Company,  and  when  the 
final  trial  was  drawing  toward  a  close  the  company 
raised  the  white  flag  and,  by  the  way,  it  was  on  the 
9th  of  April,  1914,  the  anniversary  of  Appomattox, 
and  the  surrender  was  complete.  But  the  history  of 
regulation  shows  that  where  this  policy  or  the  basic 
principles  of  equity  have  not  prevailed,  where  specula- 
tive holding  companies  have  capitalized  not  only 
what  they  paid  for  the  stock  but  the  franchises,  earning 
powers,  the  surpluses  paid  in  by  consumers  in  addi- 
tion to  fair  dividends  and  the  discharge  of  all  other 


138 


THE      UTILITIES      MAGAZINE 


obligations,  but  not  stopping  there  have  issued  more 
or  less  watered  capital,  these  questions  of  valuation 
have  again  and  again  been  raised.  And  how  shall  they 
be  answered  is  what  has  drawn  us  here  from  all  parts 
of  the  country. 

Toward  the  determination  of  a  just  and  satisfactory 
answer  I  offer  this  suggestion: 

What  is  the  financial  history  of  the  corporation 
with  which  we  are  dealing?  Whatsoever  value  there 
be  found  in  the  real  estate,  the  pipes,  the  holders,  the 
generating  station  and  every  implement  and  appliance, 
—whence  came  the  money  that  paid  for  them?  Did 
it  come  out  of  the  stockholders'  or  out  of  the  consumers' 
pockets  in  addition  to  fair  dividends?  And  how  much 
of  this  valuation  has  been  created  by  society  or  the 
state?  Once  we  have  pushed  these  inquiries  to  com- 
pleteness, in  the  light  of  the  answers  we  can  take  up  the 
march  for  our  goal,  which  is  to  give  the  stockholders 
and  the  consumers  their  every  right — and  the  mighty 


harmonies  of  justice  that  play  in  every  true  heart  will 
give  the  music  for  our  step  to  a  righteous  decision. 

One  other  suggestion,  that  we  pray  the  courts  before 
which,  under  the  Fourteenth  Amendment,  we  are 
summoned  in  rate  cases,  that  we  pray  the  august 
tribunal  with  the  deepest  earnestness  to  make  a  dis- 
tinction between  the  law  applicable  to  property  in  the 
warring  field  of  competition  and  that  in  a  protected 
monopoly.  Let  us  beg  the  august  tribunals  not  to 
make  a  second  Dred  Scott  decision.  In  that  case  the 
court  found  that  property  in  a  slave  was  the  same 
as  in  land  or  woolen  companies  and  lo!  it  took  a 
mighty  sight  of  blood  to  reverse  that  decision. 

Gentlemen,  we  are  charged  with  duties  of  national 
importance;  let  us  perform  them  with  patience,  with 
disinterestedness,  with  sound  and  broad  reasoning  lit 
up  by  the  glow  of  inspiring  ideals,  and  I  cannot  help  but 
think,  fellow  commissioners  and  friends,  that  we  will 
bring  some  honor  to  our  state  and  country. 


GOING  VALUE  AS  AN  ELEMENT  OF  FAIR  VALUE 

By  Clifford  Thokne 

Chairman,  Iowa  Board  of  Railroad  Commissioners;  former  President  of  the  National  Association  of  Railway  Commissioners 


LET  us  first  consider  the  meaning  of  terms.  The 
curse  of  Babel  has  caused  much  trouble  in 
the  world. 

Value  is  a  matter  of  relationship  between  things.  It 
has  been  defined  as  a  ratio  in  exchange.  The  exchange 
value  of  a  business  is  controlled  by  its  earnings.  If 
that  be  the  sole  definition  of  this  term  accepted  by 
our  lexicographers,  then  it  must  be  noted  that  our 
Supreme  Court  has  added  another  meaning  to  the 
term;  because  value  for  rate  making  purposes  cannot 
be  based  on  earnings,  if  you  do  not  des\re  to  reason  in 
a  circle. 

Going  value  has  been  defined  as  that  element  of  value 
resulting  from  the  fact  that  the  property  in  question 
is  being  used  by  a  business  that  is  established,  or  by  a 
going  concern. 

The  term  "fair  value,"  of  course,  is  taken  from  that 
celebrated  passage  in  Smythe  v.  Ames,  169  U.  S. 
466,  where  Mr.  Justice  Harlan  described  the  basis 
for  the  determination  of  the  reasonableness  of  rates. 
Our  discussion  will,  therefore,  be  confined  to  a  con- 
sideration of  the  doctrines  relating  to  going  value  in 
rate  cases. 

PURPOSE  OF  VALUATION 

There  are  some  who  have  claimed  that  there  is  a 
so-called  "true"  value,  independent  of  the  purpose 
for  which  an  article  is  to  be  used.     We  can  not  give 


our  consent  to  that  proposition.  Early  in  the  discus- 
sion it  will  be  well  for  us  to  squarely  face  that  issue, 
and  arrive  at  a  definite  conclusion. 

In  a  Federal  court  case  Judge  Farrington  once  held: 
"The  idea  that  a  valuable  franchise  could  be  taken  in 
condemnation  proceedings,  without  compensation, 
would  not  be  tolerated  for  an  instant;  and  to  permit 
such  a  franchise  to  be  taken  without  consideration, 
indirectly,  by  means  of  rate  regulation,  is  equally 
obnoxious  to  the  federal  constitution."  (Spring  Val- 
ley Water  Co.  v.  City  and  County  of  San  Francisco, 
165  Fed.  667,  693.)  In  support  of  this  proposition 
the  court  cited  two  cases — Spring  Valley  Waterworks 
V.  City  and  County  of  San  Francisco,  124  Fed.  574, 
and  Consolidated  Gas  Co.  v.  New  York,  in  the  lower 
Federal  courts,  being  reported  in  157  Fed.  849.  It  is 
true  it  was  there  held  that  the  franchise  value  must 
be  included  in  the  value  for  rate  making  purposes. 
This  decision  in  the  California  Federal  court  was 
rendered  in  October,  1908,  and  during  the  1908  October 
term,  on  the  12th  day  of  the  following  January,  the 
Supreme  Court  of  the  United  States,  on  appeal,  in 
Willcox  V.  Consolidated  Gas  Co.,  212  U.  S.  19,  declined 
to  include  any  of  the  franchise  value,  except  that 
portion  formerly  established  under  a  special  statutory 
provision.  The  Gas  Company  claimed  that  "the 
State  having  taxed  it  upon  its  franchises  cannot  be 


GOING      VALUE 


139 


heard  to  deny  their  existence  on  their  value  as  taxed" 
(p.  51).  The  court  held,  "the  fact  that  the  State  has 
taxed  the  company  upon  its  franchises  at  a  greater 
value  than  is  awarded  them  here,  is  not  material" 
(p.  51).  The  taxes  were  treated  as  a  part  of  the  operat- 
ing expenses,  over  and  above  which  the  company  was 
entitled  to  an  adequate  return. 

The  differences  in  principles  applicable  to  rate  cases, 
and  purchase  cases,  have  also  been  specifically  recog- 
nized by  the  Supreme  Court  of  the  United  States.  A 
leading  case  involving  the  doctrine  of  "going  value," 
in  a  purchase  and  sale  case,  is  Kansas  City  v.  National 
Waterworks  Co.,  62  Fed.  853. 

Mr.  Justice  Lurton  in  Omaha  v.  Omaha  Water  Co., 
218  U.  S.  180,  202,  decided  in  1910,  speaking  of  "the 
commercial  value  of  the  business  as  a  going  concern," 
as  distinguished  from  cost  of  duplication  less  depre- 
ciation, and  good  will,  referred 
with  approval  to  the  doctrines 
laid  down  in  the  Kansas  City 
Waterworks  Case,  subsequently 
followed  in  Gloucester  Water 
Supply  Co.  V.  Gloucester,  179 
Mass.  365,  and  Norwich  Gas 
&  Electric  Co.  v.  City  of  Nor- 
wich, 76  Conn.  565,  none  of 
which  were  rate  cases.  Mr. 
Justice  Lurton  added:  "No 
such  question  was  considered 
in  either  Knoxville  v.  Knoxville 
Water  Co.,  212  U.  S.  1,  or  in 

Willcox  V.  Consolidated  Gas  Co.,     

212  U.  S.  19.     Both  cases  were 

rate  cases,  and  did  not  concern  the  ascertainment  of 

value  under  contracts  of  sale." 

It  must  be  accepted  as  a  settled  doctrine  that  the 
elements  of  value  differ,  owing  to  the  purpose  for  which 
the  valuation  is  being  determined. 

We  will  endeavor  to  confine  our  attention,  so  far  as 
possible,  to  a  consideration  of  the  determination  of 
values  for  rate  making  purposes,  rather  than  to  venture 
out  into  a  dissertation  upon  values  for  taxation,  con- 
demnation, and  capitalization  purposes,  accompanied 
by  a  discussion  of  the  differences  between  them. 

Property  values  may  be  classified  under  two  heads: 
tangible  and  intangible.  That  which  is  tangible  can 
be  seen  or  felt,  and  is  more  easily  arrived  at,  than  that 
which  is  intangible. 

INTANGIBLE  VALUES 

The  variations  in  valuations  determined  by  experts 
are  amazing;  and  one  principal  source  of  this  variation 
is  in  the  method  adopted  for  the  determination  of  in- 
tangible values.    That  does  not  mean  that  there  are 


"I  believe  the  following  states  the  law  of  today, 
as  established  by  the  weight  of  authority: 

"Justice  to  the  owners,  and  the  best  interests  of 
the  public,  demand  that  legitimate  expenses  for 
which  a  company  has  not  been  compensated,  ex- 
penses necessary  and  actually  incurred  in  the  orig- 
inal construction  and  establishment  upon  a  paying 
basis  of  a  public  utility,  reasonably  necessary  for 
public  use,  prudently  constructed,  and  wisely  man- 
aged, should  either  be  returned  to  the  owners,  or 
should  constitute  a  part  of  the  value  upon  which 
the  said  owners  are  entitled  to  an  adequate  return. 
I  believe  there  is  money  awaiting  investment  on 
reasonable  terms,  where  that,  and  nothing  more,  is 
assiued." 

HON.  CLIFFORD  THORNE. 


no  difficulties  in  the  determination  of  tangible  values; 
for  they  are  many,  and  of  large  proportions.  Going 
value,  according  to  the  conception  of  many,  consti- 
tutes a  large  part  of  intangible  value;  in  fact,  it  con- 
stitutes one  of  the  chief  battlegrounds  between  utilities 
and  cities  at  the  present  time,  so  far  as  intangible 
values  are  concerned. 

Our  utility  companies  have  naturally  sought  to 
devise  methods  by  which  they  can  add  to  the  actual 
value  of  their  tangible  assets  a  large  intangible  value, 
with  which  to  support  the  earnings  they  have  been 
receiving  in  former  years,  or  better  still,  sustain 
increases. 

GOING  VALUE  AND  GOOD  WILL 

There  is  much  in  the  cases  to  show  that  the  ordinary 
conception  of  "going  value"  includes  what  was  for- 

merly    referred    to    as    "good 

will."  This  is  true  both  be- 
cause of  the  factors  creating 
the  value  considered  by  these 
gentlemen,  and  also  because  of 
the  percentage,  or  amount,  al- 
lowed for  going  value,  and  good 
will. 

It  matters  little  what  terms 
are  used.  What  concerns  us  is 
the  amount  of  money  allowed. 
Let  us  consider  both  of  these 
propositions  for  a  few  moments. 
Lord  Eldon  defines  good  will 
to  be  "nothing  more  than  the 
probability  that  the  old  cus- 
tomers will  resort  to  the  old  place."  John  W.  Alvord 
defines  going  value  as  the  value  of  a  created  income, 
adding :  ' '  thoughtful  consideration  of  going  value  shows 
that  it  has  no  existence  without  earnings."  In  other 
words,  in  the  case  of  a  thorougly  completed  water  plant 
connected  with  all  of  its  customers,  and  conducting  a 
large  business,  if  for  some  reason  on  and  after  a  certain 
date  none  of  those  customers  would  purchase  any  more 
water  from  the  said  company,  the  going  value  of  that 
property  on  that  date  would  be  nil.  Going  value,  with 
that  meaning  of  the  term,  would  seem  to  depend 
entirely  upon  the  good  will  as  defined  by  Lord  Eldon. 
If  there  were  no  probability  that  the  old  customers 
would  resort  to  the  old  place,  there  would  be  no  going 
value,  and  no  good  will  value,  as  defined  by  Lord 
Eldon  and  Mr.  Alvord. 

Commenting  on  Lord  Eldon's  definition,  Vice- 
Chancellor  Wood  stated  that  good  will  "must  mean 
every  positive  advantage  that  has  been  acquired 
by  the  old  firm  in  the  progress  of  its  business,  whether 
connected  with  the  premises  in  which  the  business 


140 


THE      UTILITIES      MAGAZINE 


was  previously  carried  on,  or  with  the  name  of  the 
late  firm,"  etc.' 
Again,  the  Supreme  Court  of  the  United  States  says : 

"Undoubtedly,  good  will  is  in  many  cases  a  valuable 
thing,  although  there  is  difficulty  in  deciding  accurately 
Avhat  is  included  under  the  term.  It  is  tangible  only  as  an 
incident,  as  connected  with  a  going  concern  or  business 
having  locality  or  name,  and  is  not  susceptible  of  being 
disposed  of  independently."  (Metropolitan  Bank  v.  St. 
Louis  Dispatch  Co.,  149  U.  S.  436,  37  L.  Ed.  799.) 

These  terms  are  all  closely  interlaced,  and  related 
to  each  other.  The  franchise  value  of  a  public  utility 
has  frequently  been  used  to  embrace  all  such  factors 
as  going  value,  good  will,  the  worth  of  the  business,  etc. 

The  New  Jersey  Commission  uses  the  term  "going 
value"  as  inclusive  of  intangible  values.  This  conclu- 
sion was  based  largely  upon  the  testimony  of  one  wit- 
ness in  the  case,  Mr.  Royce.''  Mr.  Royce's  definition 
of  going  value  was  framed  in  the  following  words : 

"Practically  all  elements  of  value  which  the  company 
may  possess  outside  of  its  actual  structural  value  and  the 
tangible  worth  and  value  of  its  quick  assets." 

Mr.  Royce  testified  that  he  includes: 

"Whatever  value  would  attach  to  the  franchise  value  of 
(or?)  advantage  for  the  value  of  a  going  business,  a  live 
business,  producing  a  profit;  the  prospective  increase  and 
the  opportunity  for  the  investment  of  additional  capital  in 
enlargements,  and  all  that." 

Approximately  251  per  cent  was  allowed  for  fran- 
chise value  by  the  lower  Federal  court  in  the  Consol- 
idated Gas  Case,  212  U.  S.  19,  where  several  of  the 
companies  consolidated  had  paid  dividends  ever  since 
their  creation,  averaging  16  per  cent,  and  six  companies 
had  paid  18  per  cent  and  earned  25  per  cent  during 
the  year  1884,  when  the  franchise  value  was  estimated 
under  statutory  authority,  at  the  percentage  stated 
above.  That  allowance  is  not  very  much  in  excess 
of  some  of  those  now  being  urged  for  going  value 
alone,  where  the  profitableness  of  the  business  is  but  a 
fractional  part  of  the  enormous  profit  the  Consohdated 
Gas  Co.  was  earning  at  that  time. 

It  will  be  noted  that  the  25|  per  cent  allowance  for 
franchise  value  in  the  Consolidated  Gas  Case  was 
intended  to  cover  an  increase  in  the  franchise  value 
occasioned  by  the  growth  of  the  business  during  a 
period  of  over  twenty  years.  The  Supreme  Court 
disapproved  of  this  franchise  value,  and  allowed  only 
that  portion  which  had  been  arrived  at  in  1884  which 
was  "fiixed  and  agreed  upon  under  the  Act  of  1884 
as  conclusive  at  that  time." 

In  order  to  make  the  percentage  strictly  comparable, 

» See  Menendez  v.  EoU,  128  U.  S.  514,  622. 

« In  r«  Public  Service  Gas  Case,  1  N.  J.  Rep.  483,  477. 


there  must  be  a  slight  reduction  in  the  30  per  cent 
allowed  for  going  value  by  the  New  Jersey  Commission 
in  the  Public  Service  Gas  Case,  supra,  for  their  per- 
centage was  only  applied  to  the  structural  value  of  the 
company's  property. 

It  is  true  that  the  item  "going  value"  was  not  dis- 
cussed or  put  in  issue,  as  such,  in  the  Consolidated  Gas 
Case;  but  that  phrase  represents  a  substitute  for  all, 
or  a  part,  of  those  factors  which  the  Consolidated  Gas 
Co.  did  put  in  issue,  as  representing  its  intangible 
property. 

In  the  Cedar  Rapids  Gas  Case  the  Supreme  Court 
of  Iowa  used  the  term  going  value  as  almost  synony- 
mous with  good  will.  Likewise,  Judge  Sloan,  the 
master  in  the  Des  Moines  Gas  Case,  35  Sup.  Ct.  Rep. 
811,  held  the  two  terms  to  be  practically  synonymous. 
In  both  cases  the  amount  claimed  was  denied;  and  in 
both  cases  the  United  States  Supreme  Court  sustained 
such  refusal. 

VARIATIONS  IN  VALUATION 

Mr.  Floy,  in  his  work  on  valuation,  says  in  regard 
to  going  value: 

"There  is  no  element  included  in  the  total  valuation  of 
utility  property  concerning  which  there  is  greater  difference 
of  opinion  or  more  controversy  and  indefiniteness  with  regard 
to  methods  of  its  valuation." 

We  all  agree  that  experts  are  honest,  and  we  also 
agree  that  there  is,  and  always  will  be,  wide  room  for 
variations  in  judgment  as  to  values.  But  it  is  an  inter- 
esting coincidence  to  note  that  when  a  city  and  a 
company  employ  their  experts,  and  the  findings  are 
submitted,  under  oath,  by  these  witnesses,  giving  the 
results  of  their  best  thought,  and  training,  and  investi- 
gation, to  the  court  or  commission,  the  higher  values 
are  invariably  those  prepared  by  the  men  employed  by 
the  utility  company.  I  attack  the  integrity  of  no 
person.  I  merely  suggest  this  as  an  interesting  coin- 
cidence; that  is  all. 

There  may  be  exceptions  to  the  law  of  chance,  gov- 
erning the  testimony  of  experts,  as  just  stated;  but 
I  have  found  not  one  instance  in  the  scores  of  valuation 
cases  which  I  have  had  occasion  to  read.  This  would 
make  a  very  valuable  example  for  the  critical  analysis 
of  the  psychologist,  or  the  learned  student  of  experi- 
mental ethics,  wherein  the  golden  rule  is  charge  what 
the  traflSc  will  bear;  or,  translated  into  plain,  ordinary 
English,  get  all  you  can. 

It  is  not  fair  to  imply  dishonesty  in  the  ordinary 
valuation  experts.  The  differences  exist  largely  in 
methods  followed.  Some  of  the  variations  in  methods 
have  become  storm  centers  for  unending  discussions 
by  courts,  commissions,  attorneys,  witnesses  and 
students. 


GOING      VALUE 


141 


As  you  all  know,  these  variations  are  not  mythical 
nor  theoretical,  but  real  and  tangible,  when  reduced 
to  dollars  and  cents.  One  illustration  at  random  will 
be  cited.  In  Spring  Valley  Water  Co.  v.  San  Fran- 
cisco, reported  in  165  Fed.  667,  685,  eleven  valua- 
tions were  introduced  in  the  evidence.  The  lowest 
made  by  the  company  was  higher  than  the  highest 
made  by  any  of  the  experts  employed  by  either  the 
city  or  the  county.  Two  of  these  appraisals  of  the 
same  property,  in  the  same  case,  for  the  same  purpose, 
varied  more  than  300  per  cent.  This  may  be  unusual; 
but  it  's  very  ordinary  to  find  variations  ranging  from 
100  to  150  per  cent.  When  appraisals  vary  100  per 
cent,  an  investment  in  a  shrewd,  capable  persuasive 
expert  is  about  as  wise  as  an  investment  in  a  gas  plant. 
One  will  yield  the  same  return  as  the  other;  and  the 
expert  won't  blow  up,  under  ordinary  circumstances. 

Not  oaly  do  expert  witnesses  vary  largely  in  their 
estimates,  but  commissions  and  courts  also  vary, 
greatly,  in  their  conclusions.  In  1913  one  eastern 
state  commission  held  that  a  gas  company  was  entitled 
to  a  return  upon  the  cost  of  reproduction,  new,  plus  a 
blanket  allowance  of  30  per  cent  on  structural  value; 
and  further,  that  the  company  was  entitled,  over  and 
above  operating  expenses  and  taxes,  to  an  amount 
equal  to  8  per  cent  on  the  entire  tangible  and  intangible 
value  of  the  property,  in  addition  to  a  2  per  cent  depre- 
ciation allowance,  making  in  all  about  10  per  cent  on 
the  property. 

About  the  same  time,  as  referred  to  in  the  preceding 
paragraph,  a  distinguished  gentleman,  who  was  chair- 
man of  the  New  York  Commission,  2d  District,  held 
that  a  company  was  entitled  to  no  allowance  whatever 
for  going  value,  unless  it  could  show  early  losses  that 
had  not  been  adequately  recouped  in  later  years. 
And  further,  speaking  for  the  Commission,  he  held 
that  there  was  an  abundance  of  money,  awaiting  in- 
vestment in  this  class  of  securities  at  6  per  cent  or  less. 
The  latter  gentleman  lost  his  job;  but  he  was  a  man  of 
such  sagacity  and  ability  that  one  of  the  greatest  rail- 
way systems  in  America  immediately  employed  him 
as  their  attorney.     He  is  with  us  at  this  conference. 

METHODS   OF   DETERMINING   AMOUNT   OF 
GOmG  VALUE 

In  determining  the  amount  to  be  allowed  for  going 
value,  or  development  cost,  both  the  utility  and  the 
public  are  most  profoundly  concerned  in  the  method 
of  computation;  for,  upon  that  issue  depends  the 
amount  of  money  allowed. 

Various  methods  have  been  proposed  and  rejected, 
or  approved,  by  different  tribunals.  The  consideration 
of  these  methods  raises  several  important  issues. 

When  there  is  no  proof  of  losses,  not   recovered   in 


later  years,  shall  a  blanket  theoretical  allowance  be 
made,  or  what  will  be  the  presumption  adopted? 

If  the  property  has  earned  a  reasonable  return 
during  its  entire  history,  shall  any  allowance  be  made 
for  the  present  worth  of  its  developed  business,  or  for 
the  cost  of  the  development  of  said  business? 

Shall  early  losses  be  offset  by  later  profits? 

Shall  the  allowance  be  confined  to  expenses  actually 
incurred  during  the  early  years  of  the  plant,  when  it 
was  in  the  experimental  stage;  or  shall  allowance  be 
made  for  the  cost,  or  present  worth,  of  the  entire 
existing  business  possessed  by  the  company,  by  an 
attempted  capitalization  of  the  deficits  in  operation, 
throughout  the  entire  history  of  the  property.^ 

What  is  a  reasonable  rate  of  return,  below  which  an 
earning  should  be  considered  inadequate,  and  a  justi- 
fication for  charges  to  development  cost,  or  going  value? 

Shall  the  allowance  be  made  on  the  so-called  com- 
parative plant  basis,  or  by  the  capitaUzation  of  deficits? 

Shall  the  allowance  be  made  by  adding  to  the  value 
of  the  property,  upon  which  the  company  is  entitled 
to  demand  a  return;  or  by  allowing  higher  rates  of 
return  temporarily? 

Time  will  forbid  an  adequate  discussion  upon  all 
these  propositions;  but  we  will  endeavor  to  present 
some  phases  of  the  problems  raised. 

PRESENT  WORTH  OF  ENTIRE  BUSINESS 

In  determining  the  value  of  a  plant  for  rate  making 
purposes,  shall  allowance  be  made  for  the  cost,  or 
present  worth,  of  creating  the  entire  existing  business 
possessed  by  a  company,  or  shall  it  be  confined  to 
expenses,  actually  incurred,  necessary  and  uncompen- 
sated, during  the  early  years  of  the  plant,  when  it 
was  in  the  experimental  stage,  and  before  it  was  placed 
on  a  paying  basis? 

On  the  one  hand,  we  have  such  eminent  authorities 
as  the  Wisconsin  Commission,  the  New  Jersey  Com- 
mission, and  Messrs.  Alvord  and  Metcalf,  supporting 
the  proposition  that  it  is  the  cost  of  producing  the 
existing  business,  in  the  present  condition,  or  the 
present  worth  of  those  expenditures  so  made,  during 
the  entire  history  of  the  plant,  which  should  be  con- 
sidered. 

On  the  other  hand,  we  have  such  eminent  authorities 
as  the  New  York  Public  Service  Commission,  1st 
District,  the  New  York  Public  Service  Commission, 
2d  District,  the  New  Hampshire,  Missouri,  Oklahoma, 
Georgia,  North  Carolina,  Idaho,  Arizona,  Masssachu- 
setts,  and  Connecticut  commissions,  and  a  number  of 
experts,  such  as  Professor  Bemis,  who  confine  the 
allowance  to  actual  proof  of  expenditures  during  the 
early  experimental  or  development  period,  until  the 
property  was  placed  on  a  paying  basis. 


142 


THE      UTILITIES      MAGAZINE 


More  recently,  the  New  Jersey  Commission  has 
confined  its  consideration  to  the  first  four  years  in  the 
life  of  a  certain  company  involved  in  one  of  their 
cases,  by  reason  of  the  fact  that  the  said  company 
estimated  that  it  would  take  them  that  long  to  get  on 
to  a  paying  basis. 

On  the  issue  we  are  here  discussing  there  are  not  over 
three  decisions  of  the  Supreme  Court  of  the  United 
States  in  point. 

The  first  rate  case  before  the  Supreme  Court  involv- 
ing the  element  of  going  value  was  Knoxville  v.  Knox- 
ville  Water  Co.,  212  U.  S.  1.  The  Supreme  Court  did 
not  find  it  necessary  to  decide  the  issue  presented,  but 
left  the  question  to  be  considered  when  it  might  neces- 
sarily arise  in  the  future. 

In  the  Consolidated  Gas  Case,  the  lower  Federal 
court  allowed  for  the  value  of  the  franchises  as  of  the 
year  1884,  but  found  an  increase  of  over  25  per  cent 
in  the  tangible  assets  of  the  property  twenty-three 
years  later,  and  the  coiu-t  also  found  an  increase  in 
the  business  of  almost  400  per  cent.  If  the  franchise 
was  worth  $7,000,000  in  1884,  the  court  felt  that  it 
was  worth  at  least  $12,000,000  in  1907,  assuming  the 
value  of  the  business,  or  the  franchise  value,  increased 
in  the  same  ratio  as  the  value  of  the  tangible  property. 
The  Supreme  Court  stated  on  this  issue: 

"But  although  the  state  ought,  for  these  reasons,  to  be 
bound  to  recognize  the  value  agreed  upon  in  1884  as  part 
of  the  property  upon  which  a  reasonable  return  can  be 
demanded,  we  do  not  think  an  increase  in  that  valuation 
ought  to  be  allowed  upon  the  theory  suggested  by  the  court 
below.  Because  the  amount  of  gas  supplied  has  increased 
to  the  extent  stated,  and  the  other  and  tangible  property  of 
the  corporations  has  increased  so  largely  in  value,  is  not,  as 
it  seems  to  us,  any  reason  for  attributing  a  like  proportional 
increase  in  the  value  of  the  franchises."  (Willcox  v.  Con- 
solidated Gas  Co.,  212  U.  S.  19,  47.) 

As  a  reason  for  this  conclusion  the  court  said  that 
the  former  value  of  the  franchises  was  founded  upon 
the  opportunity  of  obtaining  enormous  and  excessive 
returns  upon  the  property  in  the  company  without  any 
legislative  interference  with  the  price  of  gas.  This 
decision  clearly  indicates  that  the  growth  or  develop- 
ment of  the  business  is  not  a  matter  of  valual  ion. 

The  leading  rate  case  at  the  present  time  involving 
the  issue  of  an  allowance  for  going  value  is  Des  Moines 
Gas  Co.  V.  Des  Moines,  decided  on  June  14,  1915. 
(35  Sup.  Ct.  Rep.  811.) 

There  was  a  disagreement  between  counsel  as  to 
whether  or  not  the  master  did  in  fact  make  a  certain 
allowance  of  $300,000  for  going  value.  The  Supreme 
Court  holds  that  the  master  did  not  include  the  said 
$300,000  in  the  total  valuation  of  the  plant.  Whether 
or  not  the  master  did  make  suflScient  allowance,  other- 


wise, for  the  value  of  an  assembled  and  established 
business,  earning  money,  was  the  controlling  issue  in 
the  case. 

There  are  two  distinct  periods  in  the  life  of  this 
utility,  common  to  all  public  utilities,  that  must  be 
borne  in  mind.  First,  we  have  the  inception,  or 
experimental  stage,  of  the  business;  and  second,  there 
is  the  gradual  development  up  to  the  present  size  and 
character. 

The  issue  we  are  now  considering  involves  the 
second  stage,  or  the  second  portion  of  the  life  of  the 
company.  The  master  estimated  the  worth  of  the 
business,  as  developed,  to  be  $300,000.  In  this,  he 
stated  that  he  did  not  include  the  element  of  good  will, 
as  ordinarily  applied  to  a  merchant  or  manufacturer. 
Without  a  business,  he  said,  no  matter  how  perfectly 
the  plant  may  be  built,  it  would  be  unprofitable. 
There  is  a  great  difference,  he  added,  between  such  a 
plant  as  was  involved  in  this  case,  and  one  whose 
business  must  be  developed.  He  included  "simply 
the  fact  that  it  has  a  developed  business,  that  will 
make  money  for  its  owner,  with  reasonable  rates 
allowed  for  the  product  which  it  manufactures  and 
sells." 

At  first,  the  master  was  inclined  to  allow  this  sum 
which  he  determined  to  be  the  value  of  the  business 
as  developed.  The  decision  of  the  Supreme  Court 
in  the  Cedar  Rapids  Case  caused  the  master  to  change 
his  mind,  and  to  decline  the  allowance  he  formerly 
proposed,  of  $300,000  for  "going  value  as  a  separate 
item."  A  reference  to  the  Cedar  Rapids  Case  is  here 
necessitated. 

In  Cedar  Rapids  Gas  Light  Co.  v.  Cedar  Rapids, 
223  U.  S.  655,  669,  counsel  urged  as  one  of  the  errors 
of  the  Iowa  court,  that  nothing  was  allowed  for  going 
value.  The  Supreme  Court,  in  passing  upon  that 
issue,  stated: 

"Although  it  is  argued  that  the  court  excluded  the  going 
value,  the  court  expressly  took  into  account  the  fact  that 
the  plant  was  in  successful  operation.  What  it  excluded 
was  the  good  will  or  advantage  incident  to  the  possession  of 
a  monopoly,  so  far  as  that  might  be  supposed  to  give  the 
plaintiff  the  power  to  charge  more  than  a  reasonable  price." 
{Willcox  V.  Consolidated  Gas  Co.,  212  U.  S.  19,  52.) 

The  master  in  the  Des  Moines  Gas  Case  used  the 
term  "going  value"  in  one  place  as  including:  first, 
the  value  due  to  the  fact  that  the  plant  is  in  successful 
operation;  and,  second,  that  enhancement  which  results 
from  a  well  developed  and  paying  business.  His 
allowance,  finally  made  in  the  case,  included  the  first, 
but  excluded  the  second.  The  company's  claim  was 
that  the  exclusion  of  the  second  was  reversible  error. 

Our  query  then  becomes:  what  was  allowed  under 


GOING      VALUE 


143 


the  heading  of  the  established  business;  and  second, 
what  was  disallowed  under  the  heading  of  going  value. 
The  master  said : 

"  Were  the  City  of  Des  Moines  without  such  a  plant,  and 
such  a  one  as  the  complainant  now  owns  was  proposed,  it 
would  be  found  that  much  more  than  the  mere  cost  of  labor 
and  material  would  be  expended.  Such  expenditures  are 
termed  overhead  charges."     (35  Sup.  Ct.  Rep.  811,  815.) 

Under  this  heading  of  overhead  charges,  the  master 
listed :  Promotion  and  organization  expenses,  including 
legal  expenses,  obtaining  franchise,  and  cost  of  incor- 
poration. Second,  engineering  expenses.  Third,  losses 
due  to  accidents  to  workmen  and  materials  during 
construction.  Fourth,  contingencies.  Fifth,  cost  of 
administration,  including  time  and  money  expended 
by  persons  purchasing  material,  procuring  money,  and 
general  superintendence  during  the  construction  of 
the  plant.  Sixth,  interest  during  construction.  And 
seventh,  taxes  during  construction. 

All  of  these  expenditures  would  be  necessary  during 
the  promotion  or  construction  of  the  plant.  He  made 
no  allowance  for  overhead  charges  that  do  not  inhere 
in  and  add  to  the  cost,  as  a  part  of  the  physical  value 
of  the  plant.  In  this  way  he  arrived  at  reproduction 
cost,  new,  from  which  he  deducted  depreciation. 
Midway  between  these  overhead  charges  occurring 
during  construction,  and  the  value  due  to  that  enhance- 
ment resulting  from  the  present  well  developed  business, 
is  the  early  period,  or  experimental  stage,  placing  the 
business  on  a  paying  basis. 

The  Supreme  Court,  dealing  with  this  factor,  stated: 

"The  inception  cost  of  the  enterprise  entering  into  the 
establishing  of  a  going  concern  had  long  since  been  in- 
ciured. — It  is  not  to  be  presumed,  without  proof,  that  a 
company  is  under  the  necessity  of  making  up  losses  and 
expenditures  incidental  to  the  experimental  stage  of  its 
business."     (35  Sup.  Ct.  Rep.  811,  815.) 

The  Supreme  Court  confirmed  the  lower  court, 
sustaining  the  findings  of  the  master,  which  disallowed 
the  claim  for  $300,000  going  value,  using  that  phrase 
in  the  limited  sense  adopted  by  the  master,  and  exclud- 
ing therefrom  the  preliminary  cost  of  establishing  the 
business. 

A  similar  principle  was  clearly  recognized  by  the 
Supreme  Court  in  the  Consolidated  Gas  Case,  supra. 
Therefore,  our  conclusion  is: 

That  portion  of  going  value  which  relates  to  the  enhance- 
ment of  value  of  the  property  resulting  from  a  well  devel- 
oped and  paying  business,  as  distinct  from  the  preliminary 
cost  during  the  experimental  stage  of  establishing  the  busi- 
ness, is  not  a  part  of  the  value  of  a  property,  upon  which  a 
public  utility  is  entitled  to  demand  a  return. 


In  both  of  these  cases,  the  Cedar  Rapids  and  the 
Des  Moines  Gas  Case,  the  Supreme  Court  sustained 
the  lower  courts,  stating  that  the  said  lower  courts 
had  valued  the  property  as  in  "successful  operation"; 
and,  consequently,  the  so-called  "going  value"  had 
been  adequately  cared  for.  It  will  be  noted  that  the 
court  considers  three  things,  in  this  case:  first,  cost 
of  reproduction,  new,  less  depreciation,  and  including 
overhead  charges;  second,  the  lack  of  proof  of  any 
expenses  in  early  years,  not  recovered  in  later  years; 
and  third,  the  fact  that  the  property  was  "in  successful 
operation."  It  becomes  of  prime  importance  to 
analyze  the  meaning  of  this  phrase. 

SUCCESSFUL  OPERATION 

If  a  plant  is  able  to  pay  all  its  taxes,  operating 
expenses,  and  a  reasonable  return  on  the  actual  invest- 
ment, or  on  its  cost  of  reproduction-new-less-deprecia- 
tion, that  plant  is  in  successful  operation. 

If  the  plant  were  not  in  successful  operation,  the 
cost  of  reproduction-new-less-depreciation,  would  pro- 
duce a  sum  in  excess  of  its  present  value. 

A  given  piece  of  telephone  wire  has  several  values, 
owing  to  its  condition,  location  and  use.  When  in  a 
roll,  ready  for  sale,  it  has  a  physical  value,  new.  When 
stretched  between  poles,  as  a  part  of  a  telephone  plant, 
which  is  in  successful  operation,  it  has  an  operating 
value.  When  stretched  between  poles  as  a  part  of  a 
telephone  plant,  having  an  exclusive  franchise  for 
twenty-five  years,  it  has  a  franchise  value.  When  a 
part  of  a  plant  belonging  to  a  private  concern,  having 
a  large  patronage,  and  making  handsome  profits,  it 
has  a  good  will  value.  When  a  part  of  an  abandoned 
plant,  belonging  to  a  company  that  has  failed,  the 
wire  being  gathered  up,  and  ready  for  sale,  it  has  a 
junk  value.  When  stretched  between  poles,  and  a 
part  of  an  abandoned  plant,  it  has  a  value  less  than 
that  of  junk,  for  it  costs  something  to  gather  it  up; 
salvage  value  is  too  broad  a  term,  for  that  may  include 
junk  value,  or  may  be  even  greater;  for  lack  of  a  better 
term  we  will  refer  to  this  as  "scrap  value." 

So  the  property  of  a  public  utility  plant  may  have, 
roughly  speaking,  six  kinds  of  value;  which,  if  placed 
in  more  logical  order,  would  read  something  like  the 
following : 

1.  Scrap  value. 

2.  Junk  value. 

3.  Physical  value,  new;  not  in  place,  and  not  part 
of  an  operating  plant;  the  "bare  bones"  value. 

4.  Operating  value;  or  value  of  property  in  successful 
operation. 

5.  Franchise  value. 

6.  Good  will  value. 


144 


THE      UTILITIES      MAGAZINE 


Going  value  is  a  very  ambiguous  term,  used  in  many 
senses.  It  may  be  described  as  including  the  last 
three:  operating,  franchise,  and  good  will  values. 
Some  would  say  it  only  included  one  of  these;  others 
would  claim  it  included  all.  I  rest  my  conclusion  on 
the  use  of  the  term  going  value,  as  adopted  by  both  the 
state  and  Federal  courts,  in  the  last  two  rate  cases 
involving  the  subject  of  going  value,  which  were  car- 
ried through  to  the  court  of  last  resort:  the  Cedar 
Rapids  Gas  Co.  v.  Cedar  Rapids,  supra,  and  Des 
Moines  Gas  Co.  v.  Des  Moines,  supra. 

The  value  of  a  plant,  as  a  whole,  in  successful  opera- 
tion, is  greater  than  the  value  of  its  component  parts 
not  in  place. 

Again,  there  is  a  difference  in  value  between  a  com- 
pletely constructed  plant  in  successful  operation  with 
a  business  earning,  say,  6  per  cent  on  the  "fair  value" 
of  its  property,  and  another  plant  which  is  earning 
16  per  cent.  The  commercial  value  of  the  latter 
would  be  much  greater  than  that  of  the  former.  Those 
who  desire  to  find  tlie  value  of  the  business  belonging 
to  the  latter,  are  trying  to  find  the  commercial  value 
of  the  plant.  So  we  have  the  bare  physical  value  of 
the  component  parts,  the  value  of  those  parts  in  place, 
in  successful  operation,  and  the  commercial  value, 
which  is  measured  by  the  profits,  or  net  income,  of 
the  company. 

There  are  many  facts  which  have  been  stated  in 
decisions,  and  briefs,  showing  how  great  is  the  differ- 
ence between  the  value  of  the  physical  propertj^  alone, 
the  "bare  bones,"  and  the  value  of  the  same  property 
as  a  part  of  a  plant  in  successful  operation. 

When  a  customer  is  added  to  an  electric  light  com- 
pany's hst  of  patrons,  the  advertising,  canvassing, 
stringing  wires,  connecting  them  with  the  house,  the 
expense  of  furnishing  catalogs,  and  the  other  expenses 
connected  with  securing  that  customer,  are  all  charged 
to  operating  expenses.  It  would  be  passing  strange 
to  then  capitalize  this,  which  has  already  been  paid 
and  charged  to  operating  expenses. 

There  is  a  sort  of  going  value  which  inheres  in,  and 
is  a  part  of,  the  physical  property,  because  of  the  fact 
that  the  various  component  units  are  connected  up 
and  the  entire  structure  makes  a  complete  workable 
and  working  machine.  That  part  of  the  going  value 
which  does  not  inhere  in,  nor  become  part  of,  the 
physical  property,  applies  to  the  business  of  the  com- 
pany and  does  not  apply  to  its  property.  That  part 
is  more  fairly  described  as  the  "good  will"  of  the 
company. 

There  was  an  old,  dilapidated  building  described  in 
the  record  of  the  Des  Moines  Gas  Case,  supra.  The 
building,  it  was  stated,  would  be  worth  practically 


nothing,  were  it  not  because  it  was  connected  with 
the  plant,  in  active  operation.  In  that  capacity  its 
value  was  very  real  and  tangible. 

A  24-inch  pipe  hes  under  the  Des  Moines  River. 
If  that  pipe  were  disconnected  from  the  gas  plant, 
and  not  bearing  part  of  the  burden  of  the  completed 
machine,  nobody  would  pay  the  expense  of  removing 
the  pipe  for  what  they  could  get  out  of  it ;  and  yet,  ly- 
ing in  the  bed  of  the  river  as  a  part  of  a  going  concern, 
known  as  the  Des  Moines  Gas  Plant,  that  pipe  has  a 
substantial  value,  including  both  the  material  and  the 
labor  cost  necessitated  for  fastening  the  pipe  together, 
laying  it  properly  in  the  river,  and  connecting  it  with 
the  plant. 

It  is  only  through  being  connected  together,  and  in 
operation,  that  gives  a  value  to  these  parts  equal  to 
the  cost  of  reproduction,  new,  less  depreciation,  added 
to  the  overhead  charges. 

In  Cumberland  Telephone  &  Telegraph  Co.  v.  Citij 
of  Louisville,  187  Fed.  637,  646,  the  court  stated,  that 
in  valuing  the  property  it  would  be  looking  at  "its 
bare  bones"  if  you  did  not  take  into  consideration 
the  fact  that  the  company  was  a  going  concern.  That 
fact,  the  court  continued,  "though  possibly  somewhat 
unconsciously  to  themsleves,  must  necessarily,  we 
think,  have  been  taken  into  account  by  the  witnesses 
who  testified  as  to  values."  Property,  underground 
or  overhead,  thinly  strung  out  over  many  miles,  con- 
tinued the  court,  would  have  a  very  diminished  value, 
were  it  not  in  actual  use  for  the  purpose  for  which  it 
was  installed.  "The  matter  does  not  appear  to  have 
been  passed  upon  in  the  report,  nor,  while  it  is  argued 
in  the  brief,  does  any  exception  appear  to  be  based 
upon  this  phase  of  the  case,  but  we  have  concluded 
that  this  element  of  value,  would  hardly  be  susceptible 
of  accurate  measurement  by  and  of  itself,  and  we  shall 
consider  the  fact  to  be  that  it  was  an  inherent  factor 
in  the  estimate  made  by  each  witness  who  testified  as 
to  values." 

I  believe  Judge  Savage,  in  Brunswick  Water  District 
V.  Maine  Water  Co.,  99  Me.  371,  376,  correctly  stated 
this  principle,  as  follows: 

"We  speak  sometimes  of  a  going  concern  value  as  if  it  is, 
or  could  be  separate  and  distinct  from  structure  value, — 
so  much  for  structure  and  so  much  for  going  concern.  But 
this  is  not  an  accurate  statement.  The  going  concern  part 
of  it  has  no  existence,  except  as  a  characteristic  of  the  struc- 
ture. If  no  structures,  no  going  concern.  If  a  structure 
in  use,  it  is  a  structure  whose  value  is  affected  by  the  fact 
that  it  is  in  use.  There  is  only  one  value.  It  is  the  value 
of  the  structure  as  being  used.  That  is  all  there  is  to  it." 
{See  also  Spring  Valley  Waterworks  Co.  v.  San  Francisco, 
192  Fed.  137,  167,  168.) 


GOING      VALUE 


145 


REVIEW  OF  DECISIONS  BY  VARIOUS 
COMMISSIONS 

Mr.  Commissioner  Maltbie,  while  on  the  New  York 
Public  Service  Commission,  1st  District,  made  some 
distinguished  contributions  to  this  subject.  Most  of 
the  positions  taken  by  Mr.  Maltbie  will  be  found 
reflected  in  the  recent  decision  of  the  Supreme  Court 
of  the  United  States  in  the  Des  Moines  Gas  Case, 
especially  as  to  the  necessity  to  prove  actual  losses, 
instead  of  mere  conjectural  and  speculative  deficits  and, 
most  important  of  all,  the  confining  of  the  period  of 
development  to  the  early  experimental  stage,  rather 
than  extending  it  through  the  entire  hfe  of  the  plant. 

The  opinion  written  by  Mr.  Maltbie  in  Mayliew  v. 
Kings  County  Lighting  Co.,  2  New  York  Com.  1st 
District,  659,  has  been  reversed  recently  by  the  Appel- 
late Division  of  the  New  York  Supreme  Coiu"t  and  by 
the  Court  of  Appeals.  The  Appellate  Court  enters 
upon  a  lengthy  discussion  of  the  issues,  but  takes  posi- 
tions very  similar  to  those  adopted  by  the  Commission. 
The  ground  given  for  the  court's  reversal  is  that  no 
allowance,  or  practically  no  allowance,  was  made  for 
going  value  in  either  the  rates  or  the  valuation,  so  far 
as  the  Commission's  decision  shows.  The  paragraph 
to  which  the  court  takes  special  exception  is  as  follows : 

"It  should  be  noted  that  the  plant  has  been  in  operation 
for  nearly  twenty  years,  and  it  might  be  argued  with  con- 
siderable force  that  two  decades  should  be  sufficient  for  the 
company  to  recoup  its  early  deficiencies  below  a  fair  rate  of 
return,  if  any  such  deficiency  below  a  fair  rate  of  return, 
ever  existed.  If  the  company  has  not  recouped  itself  by 
this  time,  under  such  circumstances  it  is  doubtful  whether 
the  present  consumers  ought  to  be  burdened  for  this  reason." 
(Maykew  v.  Kings  County  Lighting  Co.,  2  New  York  Com., 
1st  D.,  659.) 

The  statement  expresses  a  doctrine  very  analogous 
to  the  one  noted  in  the  Des  Moines  Gas  Case,  where 
the  court  says: 

"It  is  not  to  be  presumed,  without  proof,  that  a  company 
is  under  the  necessity  of  making  up  losses  and  expenditures 
incidental  to  the  experimental  stage  of  its  business." 

Testimony  sustaining  Mr.  Maltbie's  position  was 
quoted  by  the  Federal  court  in  the  case  entitled  Spring 
Valley  Waterworks  Co.  v.  San  Francisco,  192  Fed.  137, 
167,  where  Mr.  Hering,  a  witness  for  the  complainant, 
testified  that  as  the  cost  of  establishing  a  business 

"has  been  or  should  have  been  covered  by  the  schedule  of 
water  rates,  further  allowance  at  the  end  of  the  term  would 
then  be  its  duplication." 

In  the  development  and  crystallization  of  these 
doctrines  which  have  been  reflected  in  the  conclusions 
arrived  at  by  the  Supreme  Court  as  to  going  value, 

10 


the  Wisconsin  Commission,  of  which  Mr.  Erickson, 
who  is  with  us  today,  has  been  such  a  distinguished 
member,  has  taken  a  leading  part  in  solidifying  the 
arguments  against  blanket  allowances  in  support  of 
the  theoretical  cost  of  the  development  of  the  business. 
The  Wisconsin  Commission  has  consistently  advocated 
confining  the  allowances  to  actual  bona  fide  losses;  the 
careful  discrimination  between  factors  worthy,  and 
those  not  worthy,  of  being  considered  in  arriving  at 
the  cost  of  development;  and  in  offsetting  losses  by 
later  profits  in  the  business.  There  is  an  able  discus- 
sion of  the  issues,  from  the  Wisconsin  Commission 
standpoint,  in  Hill  et  al.  v.  Antigo,  etc.,  3  Wis.  Com. 
623.  This  Commission  has  practically  followed  the 
historical  method,  though  some  of  the  conclusions  as 
to  the  capitalization  of  deficits  in  operation  running 
through  the  entire  life  of  the  company,  said  deficits 
not  having  been  offset,  have  failed  of  acceptance  by 
other  state  commissions,  or  by  the  courts. 

A  witness  before  the  Wisconsin  Commission  in 
State  Journal  P.  G.  Co.  v.  Madison  Gas  &  Electric  Co., 
4  Wis.  Com.  501,  sought  to  establish  a  blanket  allow- 
ance of  33§  per  cent  over  and  above  the  physical  value 
of  the  plant,  for  going  value.  It  was  sought  to  separate 
the  blanket  allowance  into  its  component  parts,  but 
the  witness  declined  to  do  so,  save  to  suggest  the 
various  elements  going  into  it.  He  gathered  his 
knowledge  from  the  pure  ethereal  haze  of  the  Divine 
atmosphere,  which  is  denied  to  us  common  mortals. 
His  testimony  had  little  weight  with  the  commission. 

The  expert  services  of  Professor  Bemis  in  many  rate 
cases,  before  commissions  and  courts,  have  been  of 
great  value  in  establishing  the  doctrines  of  requiring 
proof  of  actual  losses,  instead  of  relying  on  glittering 
generalities  and  theoretical  computations. 

A  leading  opinion  written  by  Mr.  Commissioner 
Stevens  while  on  the  New  York  Public  Service  Com- 
mission, dealing  with  these  issues,  is  entitled  Fuhrmann 
V.  Cataract  Power  and  Conduit  Company  (3  N.  Y. 
Com.,  2d  District,  656).  In  this  decision  there  is  an 
able  discussion  of  the  distinction  between  a  valuation 
for  rate  making  and  purchase.  The  Commission  holds 
that  deficits  in  operation  should  not  be  capitaUzed. 
"The  loss  is  not  an  investment  in  the  business,  but  it 
is  a  circumstance  which  may  justify  a  higher  rate 
when  the  business  does  become  remunerative  than 
would  be  just  if  no  such  loss  had  been  incurred." 
(lb.  699.) 

In  a  later  case  entitled  Fuhrmann  v.  Buffalo  General 
Elec.  Co.,  3  N.  Y.  Com.,  2d  District,  739,  the  prin- 
ciples stated  in  the  Cataract  Case  were  reaflSrmed;  the 
Commission  holding  that  those  matters  which  com- 
monly constitute  going  concern  value  should  not  be 
allowed  as  a  part  of  the  property  upon   which  the 


146 


THE      UTILITIES      MAGAZINE 


company  could  demand  a  return.     The  Commission 
adds: 

"We  also  found  that  a  situation  might  exist  in  which  the 
company  had  incurred  expenses,  or  had  deferred  profits 
at  the  commencement  of  business  during  the  unprofitable 
period  of  operation  which  sometimes  follows  the  establish- 
ment of  a  new  business,  which  would  entitle  it  fairly  and 
justly  to  a  return  from  the  public  in  increased  rates  during 
such  period  of  time  as  might  be  found  necessary  reasonably 
to  reimburse  the  company  for  these  matters."  {Fuhrmann 
V.  Buffalo  Gen.  Elec.  Co.,  3  N.  Y.  Com.,  2d  District,  769.) 

Further,  the  Commission  says  that  an  analysis  of 
the  losses  and  profits  should  be  made.  This  they  did, 
and  found  in  the  said  case  no  justification  for  the 
demand  of  allowances  for  early  losses. 

After  Mr.  Commissioner  Stevens  left  the  New  York 
Public  Service  Commission,  in  a  decision  entitled 
Application  of  Federal  Telephone  and  Telegraph  Com- 
pany (34  Commisssion  Leaflets  1081)  the  New  York 
Commission,  2d  District,  made  an  allowance  of  $150,- 
000  for  going  value.  The  Commission  did  this  on  the 
ground  of  the  decision  of  the  New  York  courts  in  their 
reversal  of  the  New  York  Commission,  1st  District, 
in  the  case  entitled  People  ex  rel.  Kings  County  Lighting 
Co.  V.  Willcox,  141  N.  Y.  Sup.  677.  The  decision  of 
the  appellate  division  of  the  New  York  Supreme 
Court  was  confirmed  by  the  Court  of  Appeals,  March 
24, 1914.  {People  ex  rel.  Kings  County  L.  C.  v.  Willcox, 
210  N.  Y.  479.) 

An  able  discussion  of  the  proposition  involved  can 
be  found  in  a  decision  of  the  New  Hampshire  Public 
Service  Commission,  entitled  Hobart  Pillshury  et  al. 
V.  People's  Gas  Light  Company  (32  Com.  Leaf.  608). 
The  New  Hampshire  Commission  states  that  if  opinion 
evidence  in  that  case  were  accepted,  it  would  support 
a  claim  of  $204,000  for  early  losses,  and  $36,000  for 
early  expenditures.  Investigation  proved,  according 
to  the  decision  of  the  Commission,  that  none  of  these 
had  ever  "existed  except  in  the  imagination  of  the 
witness."    The  Commission  adds: 

"If  the  mere  expression  of  an  opinion  by  a  witness  that  it 
cost  such  an  amount  to  secure  a  customer  or  such  an  amount 
to  build  up  a  business,  were  to  be  held  to  constitute  proof 
of  value  to  that  extent,  then  the  less  complete  the  financial 
records  of  utilities  the  more  valuable  are  their  pro|>erties  in 
most  cases. 

"It  would  seem  more  reasonable  that  a  utility  which  has 
sustained  losses,  and  knows  the  facts,  should  prove  such 
losses,  and  show  why  they  should  be  considered  as  enhancing 
value,  than  that  losses  should  be  assumed  in  all  cases  unless 
actually  disproved  by  the  representatives  of  the  public, 
who  do  not  have  knowledge  of  the  facts,  and  who  will  often 
be  unable  to  obtain  proof  thereof."  4  N.  H.  Com.  337, 
32  Com.  Leaf.  608,  665.     {See  also  Berlin  Electric  Light 


Company  Case,  3  New  Hampshire  Com.  174;  Petition  of 
Grafton  County  Elec.  L.  &  P.  Co.,  32  Com.  Leaf.  580,  587.) 

A  leading  case  before  the  Missouri  Public  Service 
Commission  is  McGregor-Noe  v.  Springfield  Gas  & 
Elec.  Co.,  1  Mo.  Com.  468.  This  decision  presents  an 
extended  discussion  of  the  principles  involved  in  the 
determination  of  going  value.  The  opinion  was  writ- 
ten by  Chairman  Atkinson  and  Commissioner  Shaw. 
Two  methods  for  determining  going  value  were  pre- 
sented, as  follows:  The  comparative  plant  method 
by  Mr.  Floy,  the  author  of  the  text-book  entitled 
"Valuation  of  Public  Utilities";  and  the  amount  of 
early  losses,  if  there  were  any,  this  being  presented 
by  Mr.  Einstein,  the  general  manager  of  the  Union 
Electric  of  St.  Louis. 

The  Commission  makes  an  able  review  of  the  deci- 
sions, and  concludes  against  making  an  allowance  for 
any  so-called  going  value,  without  proof  of  unremun- 
erated  losses,  and  cites  a  series  of  cases  where  no  such 
allowances  have  been  permitted.  {McGregor-Noe  v. 
Springfield  Gas  &  Elec.  Co.,  1  Mo.  Com.  468,  523.) 

The  Supreme  Court  of  Iowa,  in  Cedar  Rapids  Water 
Company  v.  Cedar  Rapids,  118  Iowa  234,  declined  to 
allow  anything  for  going  value  as  a  separate  factor  in 
the  valuation. 

"By  'going  value'  we  understand  is  meant  that  value 
which  arises  from  having  an  established  'going'  business. 
While  not  the  exact  equivalent  of  'good  will,'  as  applied  to 
ordinary  business,  it  is  of  a  somewhat  similar  nature,  and 
attaches  to  the  business,  rather  than  to  the  property  em- 
ployed in  such  business.  The  fact  that  the  business  is 
established  is,  of  course,  a  material  fact  in  ascertaining  the 
value  of  the  plant,  and  especially  is  this  true  where  the 
property  is  being  estimated  for  the  purposes  of  sale  or  con- 
demnation; but  as  a  basis  for  estimating  profits  its  signifi- 
cance is  less  apparent.  The  merchant  who  sells  an  estab- 
lished business  may  properly  place  a  high  value  on  the  good 
will  which  he  relinquishes  to  the  buyer;  but  so  long  as  he 
continues  in  the  enjoyment  of  the  business  he  has  created 
he  does  not  add  the  value  of  the  good  will  to  his  capital 
stock  in  estimating  the  percentage  of  his  annual  profits." 
{lb.,  262,  263.) 

Judge  Taylor  in  1909  allowed  nothing  for  going  value 
in  connection  with  the  appraisal  of  the  Clevelai\d  Street 
Ry.,  stating: 

"I  allow  nothing  for  going  value.  Going  value  raises  a 
question  of  definition,  and  it  is  sufficiently  disposed  of, 
according  to  my  view,  by  saying  that  it  only  has  a  value, 
as  applied  to  a  street-railroad  enterprise,  because  of  the 
expenses  incident  to  organization,  superintendence,  admin- 
istration, legal  expenses,  and  interest  during  construction;^ 
it  is  involved  in  the  general  subject  of  necessary  overhead 
charge,  and  arises  only  out  of,  and  is  to  be  defined  and  lim- 
ited entirely  by,  the  money  necessarily  expended  to  put  it 


GOING      VALUE 


147 


into  the  shape  where  it  has  value  as  an  operating  instru- 
mentahty.  Beyond  that,  I  recognize  no  value  to  going 
value  or  no  such  thing  as  going  value  to  be  applied  to  a 
street  railroad  enterprise."  Cited  in  re  Rates  of  Queens 
Borough  Gas  &  Electric  Co.,  2  New  York  Com.,  1st  D., 
544,  567.1 

CAPITALIZING  DEFICITS 

An  argument  urged  against  early  deficits  being  cared 
for  out  of  higher  returns  during  a  few  years,  is  that  it 
makes  a  few  consumers  bear  the  burden;  whereas  they 
should  be  spread  out  over  the  entire  life  of  the  property 
and  thereby  enable  all  to  pay  their  share.  We  are  told 
that  the  rates  should  be  low  in  the  first  few  years  of  an 
enterprise ,  in  order  to  develop  a  patronage. 
t  Let  us  consider  the  status  in  the  early  life  of  a  rail- 
road. What  was  the  condition  of  the  early  settler? 
He  went  out  into  a  new  country,  bought  his  land  at  $2 
or  $4  per  acre.  Corn  and  potatoes  were  worth  little 
until  the  railroad  came.  In  the  early  days  they  could 
afford  to  pay  high  rates.  That  enabled  them  to  sell 
crops  off  of  cheap  land,  and  then  land  values  began  to 
climb.  They  made  money  on  their  investments.  In 
somewhat  the  same  way  most  of  our  improvements  of 
a  public  character  are  of  the  greatest  value  in  the  earliest 
stages,  and  they  command  the  highest  prices  at  that 
time.  Freight  rates  first  competed  with  horses,  and 
the  charges  were  accordingly.  Later,  when  railroads 
competed  with  each  other,  the  rates  rapidly  declined 
from  20  cents  a  ton  mile  to  less  than  one  cent,  where 
they  are  today.  Automobiles,  electric  lights,  the  mail 
service,  telephone,  all  cost  the  p  iblic  the  most  in  their 
early  years. 

We  have  been  given  the  impression  that  there  is  a 
short  period  in  the  life  of  a  company,  during  its  early 
development,  when  losses  occur  and  that  these  can  be 
fairly  attributed  to  the  cost  of  establishing  or  develop- 
ing the  business.  But  we  find  these  lean  years  scat- 
tered all  through  the  life  of  a  company;  in  one  or  a  few 
years  there  is  a  great  prosperity,  and  then  a  period  of 
depression. 

The  following  tables  are  typical  selections  from  the 
decisions  of  the  Wisconsin  Commission,  which  is  the 
principal  champion  of  the  doctrine  that  losses  occurring 

•  A  few  other  decisions,  by  courts,  as  well  as  commissions,  presenting 
somewhat  similar  doctrines  to  those  we  have  described,  are  as  follows: 
Application  of  Lincoln  Tel.  &  Tel.  Co.  for  authority  to  advance  rates  (Neb- 
raska), 19  Com.  Leaf.  134;  City  of  Ely  v.  Ely  Light  &  Power  Co.  (Nevada),  24 
Com.  Leaf.  578;  Application  of  Macon  Ry.  &  Light  Co.  (Georgia),  29  Com. 
Leaf.  1072;  In  re  Haverhill  Petitions  (Massachusetts),  15  Com.  Leaf.  324; 
Petition  of  McMurray  et  al.  (Connecticut),  33  Com.  Leaf.  905,  917;  Appli- 
cation of  Pocatello  Water  Co.  (Idaho),  30  Com.  Leaf.  1347,  1365;  Bolen  v. 
Pioneer  Telephone  &  Telegraph  Co.  (Oklahoma),  27  Com.  Leaf.  Ill,  131; 
S-pring  Valley  Water  Co.  v.  CHy  and' County  of  San  Francisco,  165  Fed.  667; 
Spring  Valley  Waterworks  v.  City  and  County  of  San  Francisco,  192  Fed. 
137;  Contra  Costa  Water  Co.  v.  Oakland,  113  Pac.  668,  676. 


throughout  the  entire  life  of  a  business  should  be  capi- 
talized. 

RATE  OF  RETURN  UPON  AVERAGE  COST  OF  REPRODUCTION 

NEW 

Superior  Water,  Gas  and  Electric  Company — Electric  Department 
Year  Rat 

1890 

1891 14.60 

1892 15.00 

1893 

1894 

1895 

1896 

1897 

1898 

1899 

1900 


Leturn 

Year 

Rate  of  Return 

9.30 

1901 

87 

4.60 

1902 

1.74 

5.00 

1903 

8.87 

1904 

1.29 

5.76 

1905 

1.8« 

5.06 

1906 

2.64 

6.38 

1907 

8.85 

6.00 

1908 

7.23 

3.91 

1909 

8.90 

1910 

11.37 

i.52 

1911 

12.80 

Total 

6.69 

(Superior  Commercial  Club  v.  Superior  W.  L.  &  P.  Co.,  10  Wis.  Com.  704, 
756). 

RATE  OF  RETURN  UPON  AVERAGE  COST  OF  REPRODUCTION 

NEW 

SuPBRiOB  Water,  Gas  and  Electric  Compant — ^Water  Department 


Year 

Rate  of  Return 

Year 

Rate  of  Return 

1890 

..       1.88 

1901 

4.26 

1891 

6.87 

1902 

5.31 

1892 

..       8.43 

1903 

5.33 

1893 

..       8.23 

1904 

6.67 

1894 

8,87 

1905 

5.16 

1895 

..       8.72 

1906 

5.29 

1896 

..       7.69 

1907 

5.66 

1897 

..       5.59 

1908 

3.60 

1898 

..       4.96 

1909 

6.93 

1899 

3.98 

1910 

6.56 

1900 

4.24 

1911 

Total 

6.25 
5.83 

(Superior 

Commercial 

Club  V.  Superior  W.  L.  &  P.  Co., 

10  Wis. 

Com. 

704.  754.) 

RATE  OF  RETURN  UPON  AVERAGE  COST  OF  REPRODUCTION 

NEW 

ScPEBiOB  Water,  Gas  and  Electric  Compant — Gab  Department 


Year 

Rate  of  Return 

Year 

Rate  of  Return 

1890 

1.71 

1901 . . . 

1.43 

1891 

..     13.35 

1902... 

6.97 

1892 

..     14.38 

1903... 

5.10 

1893 

..     11.68 

1904... 

2.29 

1894 

6.84 

1905... 

5.23 

1895 

..       2.16 

1906.  . 

6.68 

1896 

1.97 

1907... 

7.76 

1897 

1.30 

1908... 

3.40 

1898 

6.15 

1909 . . . 

7.41 

1899 

1910... 

8.38 

1900 

1911... 
Total .  . 

7.87 
6.34 

(Superior 

Commercial 

Club  V.  Superior  W.  L. 

&.  P.  Co.,  10  Wis. 

Com. 

704,  755.) 

RELATION   BETWEEN  THE   NET  EARNINGS  AND   INTEREST 

CHARGES 

At  6  AND  7  per  cent.  Respectively,  on  the  Cost  of  the  Physical  Parts  of  the 

Plant,  which  Cost  is  Shown  by  the  Constrdction  Account  on 

the  Books  of  the  Company 


Year 


Surplus 


Deficits 


Year 


Surplus 


Deficits 


1891 

$3,817.61 

1900 

$306.59 

1892 

873.81 

1901 

207.29 

1893 

1,257.80 

1902 

610.18 

1894 

$2i4.45 

1903 

1,860.60 

1895 

414.56 

1904 

3,030.75 

1896 

3i4.63 

1905 

2,801.92 

1897 

26.53 

1906 

2,963.73 

1898 

369.41 

1907 

2,697.35 

1899 

.... 

503.04 

Total! 

115,034.02 

$7,236.32 


(Hill  et  al.  v.  Antigo  Water  Co.,  3  Wis.  Com.  623,  734.) 


148 


THE      UTILITIES      MAGAZINE 


MADISON  GAS  AND  ELECTRIC 

CO.— EARNING  VALUE— GAS  AND  ELECTRIC  PLANTS 

Year 

Eabninq  Vauiii 
Jan.  1 

Additions  to 

Depbeciable 

Pbopebtt 

Incbbasb  Land 
Values 

Depbeciation 
Gas  4  Feb  Cent 
Basis,  Electric 

Stbaiqht  Line 

Intebebt  8  Feb 
Cent  on  Value 

Total 

Net  Eabninob 
FROM  Operations 

Value  Deo.  31 

1896* 

$330,000 

$17,321 

$2,073 

$5,983 

$17,600 

$372,977 

$29,655 

$343,322 

1897 

343,322 

27.212 

4,020 

9,497 

27,466 

411,517 

53.247 

358,270 

1898 

358,270 

17.242 

4,020 

10,410 

28,662 

418,604 

49,060 

369,644 

1899 

369,544 

33.662 

4,020 

10,998 

29,664 

447,788 

53,267 

394,621 

1900 

894,521 

46.879 

4,020 

12,176 

31,662 

489,158 

57,458 

431,700 

1901 

431.700 

81.174 

4.020 

14,160 

34,536 

565,590 

66,700 

498,890 

1902 

498,890 

82,885 

4,020 

17,114 

39,911 

642,820 

71.108 

671,712 

1903 

671,712 

67,003 

4,020 

20,421 

45,737 

708,893 

63.355 

645,538 

1904 

645,638 

31,002 

4,020 

22,766 

61,643 

764,969 

66,059 

689,900 

1905 

689,900 

61,863 

4,020 

24,086 

66,192 

825,061 

72,367 

762,694 

1906 

752.694 

25,844 

4,020 

26,442 

60,216 

869,216 

86,091 

783,125 

1907 

783.125 

90,362 

4,020 

27,331 

62,660 

967,488 

94,321 

873,167 

1908 

873.167 

26,111 

31,737 

69.853 

1,000,868 

121,328 

879.640 

*Nine  months. 

(The  details  of  the  foregoing  table  are  discussed  in  the  opinion  of  the  Commission  to  be  found  in  State  Journal  Printing  Co.  v.  Maditon  Gas  and 
Electric  Co.,  4  Wis.  Com.  601,  683.) 


These  may  be  unusual  illustrations.  But  they  illus- 
trate the  truth  that  losses  are  scattered  through  recent 
as  well  as  early  years.  This  is  not  peculiar  to  the  utility 
business.     It  is  true  of  all  industry. 

The  suggestion  has  been  made  that  these  deficits  in 
operation  are  just  as  much  a  part  of  the  capital,  as 
interest  during  construction.  These  gentlemen  do  not 
propose  to  offset  interest  during  construction,  if  large 
profits  are  made  during  subsequent  years.  Why  not? 
The  reason  is  simple.  They,  themselves,  recognize  a 
difference  between  the  two.  Interest  during  construc- 
tion is  strictly  an  investment  cost.  The  end  of  the 
construction  period  can  be  fairly  well  located,  definitely. 
It  is  hardly  right  to  say  that  these  early  losses  are  in 
the  twilight  zone;  for  they  are  at  the  beginning,  in 
the  morning  of  the  day.  They  are  in  the  zone  of  dawn, 
a  sort  of  November  mom  affair.  You  can't  see  it, 
but  it  is  there.  It  is  diflScult  to  draw  the  line  between 
night  and  day;  but  there  is  a  difference.  It  is  likewise 
difficult  to  place  these  early  preliminary  development 
expenses.  In  some  respects  they  seem  to  belong  to 
operating  expenses,  and  otherwise  to  capital.  They 
cannot  belong  to  both.  That  invites  the  grossest  kind 
of  high  financiering.  Operating  expense  accounts, 
and  capital  accounts,  should  be  kept  as  far  apart  as 
possible.  Already  there  is  too  much  juggling  back  and 
forth,  between  the  two. 

There  are  a  multitude  of  factors  that  may^occasion 
losses  against  which  the  government  should  not  guar- 
antee immunity.  These  can  be  classified  generally 
under  ineflBcient  management,  and  the  hazards  of  the 
business,  and  are  referred  to  under  innumerable  heads 
such  as  lack  of  foresight,  extravagance,  excessive  sal- 
aries, building  too  far  ahead  for  the  future,  construc- 
tion of  a  plant  too  expensive  for  the  local  needs,  failure 
to  keep  abreast  of  the  times  in  methods  or  the  purchase 
of  improved  machinery,  general  financial  stringency. 


panic,  the  act  of  God,  such  as  earthquake,  unavoidable 
fire,  etc. 

Expenditures  occasioned  by  injudicious  investment 
are  not  to  be  considered  according  to  the  New  Jersey 
Commission.  The  thought  is  happily  phrased:  "Liv- 
ing consumers  must  not  be  held  in  the  power  of  the 
dead  hand  stretched  forth  from  the  grave  of  fictitious 
or  injudicious  investment."  Gates  &  Hurtley  v.  Dele- 
ware  &  Atl.  Tel.  &  Tel.  Co.,  1  N.  J.  Com.  519,  548. 

At  any  given  time  when  a  loss  is  suffered,  some  money 
may  have  been  expended  for  building  up  the  business 
for  the  future,  and,  at  the  same  time,  any  one  or  more 
of  the  above  factors  may  have  existed.  How  will  it 
be  humanly  possible  for  a  person  to  determine  when 
the  latter  occasioned  the  loss,  or  the  cause  was  improvi- 
dent management?  Modem  business  methods,  the 
simple  necessities  of  the  case,  require  ordinarily  some 
substantial  outlays  constantly  for  the  purpose  of  creat- 
ing new  business.  This  is  properly  considered  an 
operating  expense,  and  is  so  treated  in  the  accounts  of 
public  utilities  as  well  as  strictly  private  business 
enterprises. 

These  are  generally  subject  only  to  the  attitude,  or 
policy,  of  the  men  in  charge.  No  one  questions  the 
wisdom  of  some  of  these  expenditures;  but  it  is  cus- 
tomary to  pay  for  the  same  out  of  earnings  and  charge 
them  to  operating  expenses.  Such  expenditures  be- 
come part  and  parcel  of  the  general  operation  of  the 
plant.  Deficits  in  operation  may  or  may  not  be  due 
to  instances  of  overbuilding,  excessive  salaries,  mis- 
judging the  needs  and  demands  of  public,  etc.  A 
competent  manager  might  readily  conduct  the  same 
advertising  campaign,  pay  all  legitimate  operating 
expenses,  and  have  an  adequate  surplus  earning,  above 
capital  charges.  These  are  all  part  of  the  managerial 
scheme  of  those  controlling  the  company.  To  consider 
them  otherwise,  to  attempt  to  make  a  separation  and 


GOING      VALUE 


149 


to  find  the  cost  of  possible  losses,  would  be  fraught 
with  unending  perplexities. 

When  we  decide  to  embark  upon  the  policy  of  capi- 
talizing losses,  we  will  be  confronted  with  some  serious 
problems. 

One  firm  may  handle  a  plant  with  success  from  the 
first  or  second  year;  while  another  firm  in  the  same 
town  may  meet  with  reversals  and  constant  losses. 
How  can  we  tell  when  a  given  loss  is  the  result  of  the 
vicissitudes  of  a  business,  or  the  incompetency  of  the 
manager.'' 

What  is  a  reasonable  rate  of  return  one  year  may  be 
too  low  or  too  high  ten  years  later.  Four  per  cent 
may  be  a  reasonable  interest  rate  one  year,  and  5  per 
cent  ten  years  later.  The  rate  on  stocks  may  likewise 
increase  by  the  same  amount,  one  fourth,  or  25  per 
cent,  during  a  lapse  of  ten  years.  Many  utility  plants, 
such  as  waterworks  and  gas  plants,  established  fifty 
years  ago,  had  to  pay  one  half,  or  50  per  cent,  more 
on  their  bonds  than  similar  companies  have  to  pay 
today. 

If  we  authorize  a  company  to  capitalize  its  losses 
and  to  keep  its  profits,  it  means  that  the  public  must 
pay  a  return  on  these  losses,  it  means  the  public  bears 
the  loss  and  the  company  gets  the  profit.  It  is  there- 
fore a  one-sided  proposition;  unless,  when  you  increase 
the  capital  because  of  low  returns,  you  reduce  the 
capital  when  the  returns  are  high. 

Now  let  us  see  what  follows :  Here  is  a  company  that 
lacks  just  $10,000  of  having  enough  net  income  to  pay 
a  6  per  cent  dividend.  Shall  we  authorize  the  company 
to  capitahze  the  deficit?  If  we  do  later,  why  not  now? 
We  will  thereby  encourage  capital  to  invest,  when 
capital  learns  that  we  are  going  to  guarantee  profits. 
A  company  is  entitled  to  have  stocks  and  bonds  out- 
standing representing  all  the  property  on  which  they 
are  entitled  to  a  return,  so  we  permit  the  company  to 
issue  the  $10,000  in  bonds  and  stocks,  and  it  is  then 
able  to  pay  its  6  per  cent  dividends,  if  the  securities 
are  salable.  But  that  shocks  you!  Some  states  make 
that  action  a  penitentiary  offense.  The  arguments 
in  economics,  law,  good  finance  and  morals,  against 
that  action  are  too  long  and  too  familiar  to  justify 
repetition.  The  next  year  they  have  an  earning  of 
12  per  cent;  shall  we  then  reduce  the  stocks  and  bonds 
by  6  per  cent?  The  confusion  is  too  charming.  We 
need  not  pursue  it  further. 

Suppose  instead  of  permitting  them  to  issue  stocks 
and  bonds,  we  simply  say  that  any  year  when  you 
test  the  adequacy  of  your  returns,  you  are  entitled 
to  increase  the  value  by  the  amount  of  your  losses  and 
decrease  it  by  the  amount  of  your  extra  gains. 

Then  the  task  is  to  analyze  your  past  financial  his- 
tory.   Are  you  going  to  wade  through  the  operating 


expense  account  of  each  year  for  twenty  or  thirty  years 
past?  You  would  have  to  acquaint  yourself  with  the 
circumstances  of  the  business,  the  current  standards 
of  that  year,  the  occasion  for  this  expenditure  and  for 
that.  Or  otherwise,  you  would  have  to  accept  the 
expense  account  as  it  stands  and  that  is  the  usual  re- 
sult in  the  practical  application  of  this  method. 

The  state  thereby  becomes  for  all  practical  purposes 
a  guarantor  of  the  profits  in  that  business. 

A  state  commission  has  held  that  a  certain  company 
was  entitled  to  an  8  per  cent  return  on  the  investment 
in  the  property,  in  addition  to  an  allowance  for  depre- 
ciation, sufficient  to  replace  the  entire  property  and 
all  its  parts  as  soon  as  they  had  lived  their  natural 
life ;  also  an  8  per  cent  return  on  all  increases  in  land 
values;  also  an  8  per  cent  return  upon  all  deficits  or 
failures  to  meet  the  foregoing  requirements.  In  other 
words,  the  company  was  entitled  to  a  cumulative,  com- 
pound interest  rate  of  8  per  cent,  and  was  also  guaran- 
teed against  competition. 

If  the  policy  of  permitting  rates  to  a  monopoly  con- 
cern, which  would  yield  returns  of  that  charactc*  should 
ever  become  the  recognized  standard  in  the  United 
States,  such  securities  would  completely  outclass  the 
finest  gilt-edged  cumulative  preferred  railroad  stocks 
in  the  country,  securities  which  our  investors,  the 
nation  over,  are  willing  to  purchase  on  a  4|  per  cent  or 
5  per  cent  basis. 

It  is  not  strange  that  later  we  find  the  Wisconsin 
Commission  with  a  candor  and  honesty  of  purpose 
sufficient  to  make  a  change  in  that  rate  of  return.  In 
1911,  in  the  application  of  the  La  Crosse  Gas  and 
Electric  Co.,  the  Commission  said: 

"It  seems  quite  clear  that,  when  a  'going  value'  or  'earn- 
ing value'  determination  is  made,  the  capitalization  of 
unearned  sums  for  depreciation  and  interest  and  the  unques- 
tioning acceptance  of  the  operating  expense,  amount  to 
an  elimination  of  the  risks  of  the  business  and  that,  there- 
fore, little,  if  anything,  need  be  allowed  for  profit  above  a 
bare  interest  rate  on  the  investment  during  those  years." 
In  re-application  LaCrosse  Gas  &  Electric  Co.,  8  Wis.  Com. 
138,  181  (1911). 

There  are  several  interesting  phases  of  this  method 
of  capitalizing  deficits,  the  losses  of  certain  years  being 
offset  by  the  profits  of  other  years.  The  value  de- 
creases as  the  profit  increases;  or,  on  the  other  hand, 
the  value  increases  as  the  profit  decreases.  The 
greater  the  deficit,  the  greater  the  value.  In  other 
words,  a  deficit  creates  value.  Unless  we  are  careful, 
we  will  lose  ourselves  in  a  quagmire  of  contradictions 
and  economic  absurdities  and  impossibilities. 

If  the  losses  of  one  decade  are  capitalized,  should 
we  not  capitahze  the  losses  of  the  next;  if  the  losses 
of  one  generation  are  capitaUzed,  should  we  not  also 


150 


THE      UTILITIES      MAGAZINE 


capitalize  the  losses  of  another  generation,  and  of  the 
next,  and  so  on,  and  on,  in  the  future,  forever?  As 
business  goes  on,  in  the  course  of  a  century  we  would 
capitalize  in  the  railroad  industry,  or  for  your  water 
plant  in  your  local  community  that  has  probably 
already  been  there  a  half  century,  the  losses  of  three 
generations,  the  losses  of  ten  decades  of  business. 

Should  not  each  generation,  and  each  decade  bear 
its  own  losses?  After  the  industry  has  once  been 
placed  on  its  feet,  when  it  has  once  been  placed  on  a 
paying  basis,  ought  it  not  be  required  to  take  care  of 
itself? 

The  modern  theory  that  we  should  capitalize  losses 
is  a  new  and  unheard  of  venture  out  into  a  realm  of 
the  unknown,  a  realm  of  uncertainty  and  confusion, 
where  we  must  abandon  the  basic  principles  of  public 
pohcy  and  finance,  that  have  been  guiding  us  in  the 
past. 

What  each  generation  must  be  willing  to  pay  is  a 
reasonable  return  on  the  fair  value  of  the  property 
devoted  to  the  public  service,  at  that  time. 

If  we  permit  the  capitalization  of  losses,  at  no  future 
time  will  the  value  of  the  property  then  being  used 
by  the  public  be  the  basis  for  computing  the  adequacy 
of  returns. 

LOSSES  OFFSET  BY  PROFITS  IN  THE  PAST 

There  is  little  difference  of  opinion  in  any  of  the 
cases  upon  the  proposition  that  if  a  company  suffers 
losses  diu-ing  one  or  a  few  years,  either  in  the  early  or 
later  portion  of  its  history;  and,  afterwards,  in  addition 
to  a  reasonable  return,  that  loss  has  been  recouped  to 
the  company,  it  cannot  legitimately  ask  for  the  same 
to  be  capitalized  or  to  be  returned  to  it  again.  {Kings 
County  Lighting  Co.  v.  Willcox,  210  N.  Y.  479.) 

The  only  exception  to  this  proposition  which  we 
have  found,  is  the  decision  of  the  New  Jersey  Com- 
mission in  the  Public  Service  Gas  Case,  supra. 

Dr.  Whitten,  in  his  able  work  on  Valuation,  suggests 
that  the  New  Jersey  Commission  may  hold  differently 
as  to  rates  charged  under  regulation.  We  cannot 
adopt  the  suggestion,  as  a  deduction  from  the  decision. 
Of  course,  we  cannot  tell  what  the  Commission  will  do. 
The  decision  referred  to  rests  on  a  doctrine  of  estoppel, 
that  those  rates  may  have  been  too  high,  and  it  may 
be  "a  subject  of  regret  that  regulation  was  so  long 
deferred;  but  deferred  regulation  is  no  excuse  for 
refusing  at  present  to  allow  a  fair  return  upon  what  is 
the  lawful  property  of  the  company."  {See  In  re 
Public  Service  Gas  Co.,  1  N.  J.  Rep.  433,  475.)  If 
deferred  regulation  works  an  estoppel,  certainly  regu- 
lation existing  and  permitting  high  rates  would  be  a 
still  greater  estoppel. 


A  different  thought  enters  into  a  more  recent  decision 
by  the  same  Commission: 

"In  the  light  of  these  two  general  principles,  it  appears 
just  and  reasonable  that  a  fair  present  day  estimate  of  the 
capital  necessarily  and  judiciously  sunk  in  establishing  the 
business  and  not  thereafter  recouped  from  revenue  should 
enter  as  an  element  into  the  base  upon  which  a  fair  return 
should  be  allowed."  {Gately  &  Hurley  et  al.  v.  D.  &  A.  T. 
&  T.  Co.,  14  Com.  Leaf.  39,  68.) 

COMPARATIVE  PLANT  METHOD 

Mr.  Benezette  Williams,  in  a  letter  to  the  American 
Water  Works  Association  (published  in  connection 
with  Mr.  Alvord's  paper  on  Going  Value),  in  June, 
1909,  stated  that  the  first  rate  case  wherein  allowance 
was  made  for  going  value  was  the  Dubuque  Water- 
works appraisal.  At  that  time  there  was  clearly  stated 
the  basic  principles  of  tlie  comparative  plant  method 
of  arriving  at  going  value.  This  method  contem- 
plates a  hypothetical  plant  created  at  the  time 
of  the  valuation,  and  the  value  is  measured  by  the 
sum  of  the  yearly  amounts  of  revenue  reduced  to  pres- 
ent worth,  which  the  original  plant  in  operation 
produces  in  excess  of  what  the  new  plant  can  be  made 
to  produce,  between  the  time  of  purchase  and  that 
time  in  the  future,  when  the  revenues  of  the  two  works 
become  equal.' 

This  is  worthy  of  consideration.  Let  us  assume  the 
present  telephone  plant  in  Philadelphia  ehminated, 
and  a  new  plant  finished,  completed  in  every  respect, 
connected  with  every  home  in  this  city  which  is  now 
connected  by  the  present  plant,  and  all  the  people 
educated  in  the  use  of  telephones.  It  would  not  take 
long  to  place  that  plant  on  a  paying  basis.  The 
people  would  probably  force  it  on  to  a  paying  basis 
before  the  first  month  was  concluded.  There  would 
be  no  preliminary  development  cost,  or  going  value. ^ 

On  the  other  hand,  if  we  assume  the  present  telephone 
plant  in  Philadelphia  eliminated,  and  no  person  know- 
ing what  a  telephone  is,  there  would  probably  be  an 
extended  development  period.  But  who  would  be 
able  to  tell  how  long  it  would  take  to  create  the  demand? 
How  would  we  go  about  it  to  guess  the  period  before 
the  plant  would  be  on  a  paying  basis?  Everything 
in  your  computation  would  depend  upon  your  assump- 
tion. You  could  double  the  going  value,  or  split  it  in 
the  middle.  During  the  development  period  you  would 
certainly  build  your  plant  in  harmony  with  the  local 
demand.  There  would  be  no  occasion  for  the  present 
great  system  till  the  people  wanted  it.  That  would  be 
the  situation  in  practical  business.     Whether  it  would 

'  See  paper  above  referred  to  published  in  pamphlet  form,  at  page  247; 
also  Beloit  v.  Beloit  Water,  Gas  &  Electric  Co.,  7  Wis.  187. 

'  See  comments  of  Professor  Bemis  in  his  report  on  the  telephone  rates 
of  the  Chicago  Telephone  Co.,  under  date  of  October  25,  1912. 


GOING      VALUE 


151 


or  not  of  castles  in  the  air,  of  hypothetical  phantom 
plants  is  another  question.  If  we  assume  the  impossi- 
ble, the  impractical,  we  are  basing  regulation  on  false 
assumptions.  And  who  is  there  who  could  say  that 
the  new  plant,  built  on  small  proportions  and  enlarged 
as  the  business  justified,  would  not  pay  from  the  start, 
or  would  not  make  up  the  early  losses  within  the  first 
few  years  of  its  life.'* 

The  objection  to  the  so-called  comparative  plant 
method  can  be  briefly  summarized  under  two  heads: 

1st.  It  involves  many  assumptions,  such  as  the 
time  limit,  the  principle  of  which  is  the  time  that  it 
would  take  a  new  plant  to  produce  an  income  equal  to 
the  original  plant;  the  sum  of  money  arrived  at  depend- 
ing entirely  upon  the  character  of  the  assumption  de- 
scribed. 

2d.  The  computation  involves  net  income,  as  al- 
most a  controlling  factor.  If  the  earnings  are  produced 
by  excessive  rates  they  will  be  large  and  consequently 
require  a  longer  time  for  the  new  plant  to  duphcate 
itself.  If  the  rates  are  low,  the  earnings  are  small  and 
the  opposite  result  will  follow. 

A  computation  that  must  be  based  upon  the  assump- 
tion that  the  rates  are  reasonable,  is  of  very  little  value 
in  an  investigation  of  the  reasonableness  of  the  said 
rates.' 

Neither  the  blanket  theoretical  percentage  allowance, 
nor  the  capitalization  of  net  deficits  throughout  the 
life  of  a  plant,  nor  the  comparative  plant  method,  has 
found  favor  in  the  great  majority  of  decisions  by  either 
courts  or  commissions.  Neither  of  these  methods 
has  had  any  weight  in  the  decisions  of  the  lower 
courts,  or  of  the  Supreme  Court,  in  either  of  the  cases 
involving  these  issues,  which  have  been  carried  up  to 
the  Supreme  Court  of  the  United  States. 

CONCLUSIONS 

In  the  absence  of  actual  proof  of  early  losses  which 
have  not  been  recouped  in  later  years,  nothing  should 
be  allowed  for  the  same. 

Blanket,  theoretical  estimates  on  the  comparative 
plant,  or  other  speculative  basis,  should  not  be  adopted. 

Only  losses  occurring  during  the  first  few  years  of  an 
enterprise,  while  it  is  in  the  experimental  stage,  and 
only  such  losses  as  are  strictly  a  necessary  part  of  the 
cost  of  placing  the  enterprise  on  a  paying  basis,  and 
only  such  losses  for  which  the  company  has  never  been 
compensated,  should  be  considered.  Subsequent  losses 
should  not  be  capitalized  or  allowed  for  in  the  rate  of 
return.  Ordinarily,  no  such  preliminary  development 
costs    exist   for    which    compensation    has    not    been 

'  See  Mayhew  v.  Kings  County  Lighting  Co.,  i  N.  Y.  Com.,  1st  District 
659;  Spring  Valley  Waterworka  v.  Son  Francisco,  192  Fed.  137;  HiU  et  al. 
V.  Antigo,  3  Wis.  Com.  6iS. 


received.  It  is  doubtful  if  the  allowance  should  ever 
be  made.     We  do  not  make  law  for  special  cases. 

Whether  the  preliminary  development  costs  are 
cared  for  out  of  the  rate  of  return,  or  added  to  the  value 
upon  which  the  utility  is  entitled  to  demand  a  return, 
in  either  case,  I  believe  the  action  of  the  administrative 
tribunal  will  be  sustained  by  the  courts,  if  it  be  properly 
presented,  and  carried  to  the  court  of  last  resort. 

A  given  unit  in  a  utility  plant  is  worth  more  as  a  part 
of  a  property  in  successful  operation  than  when  by 
itself,  and  not  so  connected  and  used.  The  courts 
have  held  that  the  cost  of  reproduction  new,  less  depre- 
ciation, and  including  reasonable,  but  not  excessive, 
sums  for  overhead  charges,  makes  ample  allowance  for 
the  value  of  a  property  in  successful  operation,  in  the 
absence  of  any  actual  proof  of  unrecouped  losses  which 
were  necessarily  incurred  during  the  early  experimental 
stage,  while  the  property  was  being  placed  upon  a 
paying  basis. 

Personally,  I  do  not  approve  of  the  cost  of  reproduc- 
tion, new,  less  depreciation,  as  the  basis  for  rate  making 
purposes.  I  do  not  believe  that  the  courts  have  ever 
adopted  it  as  such,  and  I  do  not  believe  that  they  ever 
will  do  so.  On  the  other  hand,  I  do  not  believe  that 
the  courts  have  ever  adopted,  or  ever  will  adopt,  orig- 
inal cost  as  the  basis.  In  the  San  Diego  and  Minne- 
sota Rate  Cases,  the  Supreme  Court  plainly  stated 
why  that  was  so.     Both  factors  are  important. 

"  Fair  value  "  is  the  basis.  Our  friends,  the  devotees 
of  the  reproductive  theory,  have  adopted  that  term,  and 
then  calmly  proceeded  to  establish,  so  far  as  possible, 
the  cost  of  reproduction  as  the  controlling  factor.  Is 
there  not  a  lesson  here  for  you  to  learn.'*  Results  are 
what  count.  If  the  Supreme  Court  should  declare 
that  two  plus  two  make  five,  or  that  lying  is  morally 
right,  of  course  we  would  never  accept  their  dicta.  If 
the  Supreme  Court  should  declare  that  four-legged 
contrivance,  upon  which  you  are  seated,  to  be  a  table, 
instead  of  a  chair,  that  might  be  difficult  to  accept. 
We  might  try  to  get  them  to  change  their  notion.  I 
might  try  three  or  four  times;  and  then,  if  they  still 
persisted,  I  would  say,  "all  right,  that  is  a  table;  but 
this  thing  that  I  am  accustomed  to  writing  on  must  be 
called  something  else;  call  it  a  chair,  if  you  desire, 
but  you  will  have  to  call  it  something  else."  And  I 
would  succeed.  Remember,  words  and  phrases  should 
be  our  servants,  not  our  masters.  We  must  work  along 
lines  that  will  bring  results. 

Fair  value  is  only  in  the  process  of  being  defined.  It 
is  up  to  you  and  me  to  help  see  that  proper  weight  be 
given  to  the  various  elements  entering  into  "fair 
value"  as  the  basis. 

The  Supreme  Court  has  never  stated  that  the  cost 
of  reproduction,  new,  is  synonymous  with  present  fair 


152 


THE      UTILITIES      MAGAZINE 


value.  Concerning  the  absurd  extremes  to  which  that 
hypothesis  would  lead  us,  the  court  stated,  in  the 
Minnesota  Rate  Case: 

"It  is  manifest  that  an  attempt  to  estimate  what  would  be 
the  actual  cost  of  acquiring  the  right-of-way,  if  the  railroad 
were  not  there,  is  to  indulge  in  mere  specidation.  The  assump- 
tion of  its  non-existence,  and  at  the  same  time,  that  the 
values  that  rest  upon  it  remain  unchanged,  is  impossible 
and  cannot  be  entertained."  Minnesota  Rate  Cases,  210 
U.  S.,  352,  452. 

Further,  in  regard  to  this  whole  proposition,  the  court 
said: 

"The  cost-of -reproduction  method  is  of  service  in  ascer- 
taining the  present  value  of  the  plant,  when  it  is  reasonably 
applied  and  when  the  cost  of  reproducing  the  property  may 
be  ascertained  with  a  proper  degree  of  certainty.  But  it 
does  not  Justify  the  acceptance  of  results  which  depend  upon 
mere  conjecture."  (ib.) 

The  court  has  already  been  persuaded  to  reject  the 
cost  of  reproduction  in  several  important  portions  of  an 
appraisal.  Perhaps  the  most  important  achievement 
of  that  character,  up  to  the  present  moment,  was  the 
definite,  positive  position  taken  as  to  land  values  in 
the  Minnesota  Rate  Case.  Second  only  to  that  in 
importance  is  the  evolution  of  these  doctrines  which 
we  have  been  discussing  in  this  paper,  and  the  final 
rejection  in  the  Des  Moines  Gas  Case  of  the  reproduc- 
tion cost  theory  as  applied  to  "going  value"  in  the 
appraisal  of  a  public  utility  for  rate  making  purposes. 

It  is  my  belief  that  we  should  center  our  efforts  on 
the  following :  First,  that  exhaustive,  accurate  and  reli- 
able proof  be  secured  as  to  what  can  fairly  be  called 
actual  or  estimated  original  cost;  second,  that  the  cost 
of  reproduction  be  honestly  and  fairly  arrived  at,  in 
all  its  parts,  so  far  as  it  is  humanly  possible ;  and  lastly, 
and  most  impoi  tant  of  all,  that  the  facts  and  arguments 
should  be  assembled  by  men  of  known  capacity,  showing 
clearly  and  conclusively  the  relative  importance  of 
these  two  factors,  original  cost,  and  reproduction  cost, 
in  the  determination  of  values  for  rate  making  pur- 


poses; for,  I  believe  that  original  cost  is  the  most  im- 
portant factor  to  be  considered  in  the  appraisal  of  a 
public  utility  property  for  rate  making  purposes;  and, 
when  effectively  presented,  that  will  be  the  conclusion 
of  our  court  of  last  resort,  a  tribunal  for  which  I  have 
the  most  profound  regard,  a  tribunal  without  a  peer 
in  the  judicial  history  of  the  human  race. 

Concerning  this  subject  of  going  value,  I  s  ibmit  two 
queries  upon  which  I  have  not  made  up  my  own  mind, 
finally.  First,  should  loss  occasioned  by  competition 
be  considered?'  Second:  After  a  number  of  years  free 
from  regulative  interference,  should  not  a  company  be 
estopped  from  claiming  allowance  for  early  losses;  is 
not  that,  in  itself,  sufficient  proof  of  mistakes  in  con- 
struction, or  management,  or  an  evidence  of  the  usual 
hazard  in  the  business? 

Regardless  of  my  conclusions  on  these  propositions 
as  to  what  is  the  correct  doctrine,  I  believe  the  following 
states  the  law  of  today,  as  established  by  the  weight  of 
authority : 

Justice  to  the  owners,  and  the  best  interests  of  the 
public,  demand  that  legitimate  expenses  for  which  a 
company  has  not  been  compensated,  expenses  necessary 
and  actually  incurred  in  the  original  construction  and 
establishment  upon  a  paying  basis  of  a  public  utility, 
reasonably  necessary  for  public  use,  prudently  con- 
structed, and  wisely  managed,  should  either  be  returned 
to  the  owners,  or  should  constitute  a  part  of  the  value 
upon  which  the  said  owners  are  entitled  to  an  adequate 
return.  I  believe  there  is  money  awaiting  investment 
on  reasonable  terms,  where  that,  and  nothing  more,  is 
assured. 

» See  Bachrack  v.  Consolidated  Gas,  Electric  Light  &  Power  Co.  of  Balti- 
more, 14  Com.  Leaf.  154,  January  13,  1913.  Losses  occasioned  by  compe- 
tition may  be  considered  an  incident  to  the  business  which  was,  or  should 
have  been,  anticipated  by  men  embarking  in  such  an  enterprise.  It  is 
doubtful  whether  it  is  fair  to  ask  the  consumer  of  today  to  bear  the  burden 
of  that  competition. 

(Note  as  to  abbbeviations:  Com.  Leaf,  refers  to  the  publications  of 
commission  decisions  by  the  American  Telephone  &  Telegraph  Co.;  the 
various  state  railroad  and  public  service  commission  reports  are  referred 
to  simply  by  the  name  of  the  slate  and  the  abbreviation.  Com.) 


DISCUSSION 


I  desire  to  say  that  I  came  here  to  learn.  This  is  a  new 
work  for  me.  While  I  have  devoted  some  time  in  the  past 
to  studying  a  number  of  the  subjects  under  discussion,  and 
am  very  much  interested  in  their  solution,  yet  I  was  not 
expecting  to  address  this  body  at  this  time.  There  have 
been  one  or  two  suggestions  made  that  have  been  of  special 


By  Hon.  Joseph  L.  Bristow 

Chairman  of  the  Kansas  Public  Utilities  Commission 

interest  to  me.  One  was  offered  by  Mr.  Wood  of  New  York,* 
when  he  suggested  that  high  enough  rates  should  be  provided 
to  give  hberal  returns  upon  the  capital,  so  as  to  invite  the 
investment  of  additional  capital  in  these  utilities  that  they 
may  be  enlarged  and  able  to  render  greater  public  service. 
'S«  p.  171. 


GOING      VALUE 


153 


I  think  we  all  agree  on  that  proposition,  but  when  you 
consider  the  various  elements  in  the  operation  of  public 
utilities  that  lead  to  gain  or  loss,  we  certainly  find  that  there 
are  other  considerations  than  rates  that  are  of  paramount 
importance.  The  depreciation  in  the  value  of  the  securities 
of  public  utilities  in  the  United  States  during  recent  years 
has  not  been  so  much  because  of  the  inadequacy  of  the 
rates  as  of  other  matters. 

The  misuse  of  the  funds  by  those  in  control  of  many  of 
such  utilities  has  brought  disaster  to  them  and  destroyed 
their  credit.  It  is  of  the  greatest  importance  that  regulatory 
bodies  should  be  given  authority  to,  in  some  way,  enforce 
honesty  in  the  management  of  these  concerns  so  that  their 
credit  may  be  restored. 

So  far  as  the  railroads  are  concerned,  their  credit  has  been 
destroyed,  to  a  great  extent,  by  the  management  of  men  in 
control  of  their  finances.  Indeed,  it  has  been  found  by  the 
Interstate  Commerce  Commission  recently  that  one  of  the 
great  railway  systems  that  is  now  in  the  hands  of  a  receiver, 
was  placed  there  when  its  gross  receipts  were  greater  than 
during  any  other  year  in  its  history.  What  this  company 
needed  was  not  higher  rates,  but  honest  management.  So, 
gentlemen,  it  seems  to  me  that  the  other  questions  which 
affect  the  financial  standing  of  these  public  service  corpora- 
tions are  of  equal  or  greater  importance  than  the  rates  they 
are  permitted  to  charge. 

I  have  been  very  much  interested  in  the  discussion  of  the 
valuation  subject.  We  had  a  case  before  our  commission  out 
in  Kansas  the  other  day;  and  an  able  lawyer  who  appeared 
before  the  commission,  who  was  at  one  time  a  member  of  the 
United  States  Senate,  argued  with  great  force  that  the  losses 
which  the  corporation  had  incurred  during  its  operation, 
should  be  added  to  the  capital  upon  which  it  was  permitted  to 
earn  returns. 


In  another  case  it  has  been  argued  with  great  earnestness 
that  any  favorable  conditions,  such  as  location,  that  were 
of  benefit  to  a  company  and  enabled  it  to  earn  good  returns, 
were  elements  of  value  that  should  be  taken  into  considera- 
tion in  fixing  rates. 

That  is,  if  one  road  in  the  same  territory,  because  of  more 
favorable  location,  makes  handsome  profits,  then  it  is  entitled 
to  take  into  consideration  the  value  of  such  location  in 
fixing  a  value  for  rate  making.  In  the  other  case,  if  its 
location  is  bad  and  because  of  that  or  other  facts  it  is  operated 
at  a  loss,  such  loss  entitles  the  road  to  increased  rates. 

This  appears  to  me  to  be  a  scheme  for  catching  them 
"comin'  and  goin'." 

Now  I  am  not  expert  enough,  yet,  to  determine  just  where 
to  draw  the  proper  line  ultimately,  in  ascertaining  the  value 
of  a  property  upon  which  the  commission  is  to  fix  rates. 
That  is  destined  to  become  a  question  of  great  economic  and 
political  controversy. 

I  was  very  favorably  impressed,  indeed,  with  the  very 
eloquent  and,  to  my  mind,  sound  remarks  made  by  our 
chairman  this  afternoon.'  It  seemed  to  me  that  he  outlined 
in  a  very  clear  manner  a  basis  that  would  be  equitable  and 
just.  And  I  am  disposed  to  accept  it,  giving  peculiar  and 
particular  emphasis  upon  the  fact  that  an  honest,  efficient 
and  economic  administration  of  the  corporation's  affairs 
shall  always  be  required;  that  the  investments  in  such 
properties  shall  be  wisely  made.  Otherwise,  you  are  giving 
a  premium  upon  wastefulness  and  unwise  investments,  and 
not  imposing  a  penalty  upon  extravagance,  dishonesty  and 
improvidence  in  operation.  I  feel  that  such  conferences  as 
this  in  which  we  are  now  engaged  will  be  of  great  value  to 
the  country. 

»Se»p.  187. 


GOING  VALUE  IN  PURCHASE  VS.  RATE  CASES 

By  a.  M.  Fox 
Former  Instructor,  Engineering  Department,  University  of  Michigan;  Assistant  Engineer,  Telephone  Appraisal,  City  of  Detroit 


This  discussion  is  intended  to  deal  primarily  with  going 
value  as  an  element  of  fair  value  in  rate  cases  in  contra- 
distinction to  purchase  cases. 

Public  utilities  contain  property  of  value  which  does  not 
show  in  the  inventory  of  the  property.  These  intangible 
elements  are  the  source  of  great  controversy  and  account 
for  the  glaring  discrepancies  that  apparently  exist  between 
valuations  of  the  same  property  by  different  appraisers. 
The  proper  treatment  of  intangible  elements  is  indeed  one 
of  the  most  difficidt  and  puzzling  questions  confronting 
the  appraiser  in  ascertaining  the  value  of  a  property  for  rate 
making  purposes.  The  great  confusion  of  thought  upon 
this  subject  arises  from  the  failure  to  differentiate  carefully 
between  the  several  elements  of  fair  value  for  rate  and 
purchase  cases  as  applied  to  intangible  capital. 

It  is  hardly  necessary  to  remind  this  audience  that  the 
first  appraisals  were  taken  in  connection  with  the  purchase 


of  public  utilities,  originating  in  the  purchase  of  waterworks. 
Those  for  rate  making  purposes  are  of  a  comparatively 
more  recent  date.  It  is  natural,  therefore,  that  the  principles 
and  appraisal  bases  established  in  purchase  cases  should  have 
been  carried  over  into  rate  cases,  with  only  slight  modifica- 
tions. This  is  especially  true  of  the  intangible  values  of 
public  service  utilities.  Careful  analysis  will  reveal  the 
fact  that  equity  and  justice  demand  that  different  treatment 
be  accorded  going  value  for  purchase  and  rate  purposes. 

The  intangible  elements  of  a  utility  which  do  not  appear 
in  an  inventory  of  a  property,  but  which  are  nevertheless 
important  elements  of  value  are  the  following: 

1.  Undistributed  overhead  or  general  expenses, 

2.  Cost  of  developing  the  organization, 

3.  Going  value. 

Of  these  ^the  undistributed  or  overhead  expenses,  which 
represent  merely  directive  labor,  and  the  cost  of  developing 


154 


THE      UTILITIES      MAGAZINE 


the  organization,  an  essential  part  of  every  utility,  are 
considered  to  be  proper  charges  to  the  capital  account,  and 
ought,  really,  to  be  included  in  the  physical  value  in  both 
rate  and  purchase  cases.  In  fact,  engineers  do  as  a  rule 
include  these  in  appraisals.  When  the  proper  allowances 
are  made  for  these  in  the  ascertainment  of  fair  value  for  rate 
making  purposes,  it  is  believed  that  no  consideration 
need  be  given  to  going  value,  which  represents  an  increment 
of  value  of  a  property  resulting  from  its  earning  capacity, 
earning  capacity  being  the  matter  at  issue  in  a  rate  case 
and  therefore  to  be  excluded  in  determining  the  base. 

Going  value  has  been  variously  defined  to  include  all  of  the 
intangible  elements.  This  tendency  and  condition  although 
conducive  to  pressing  the  claims  and  self-interest  of  advocates 
may  be  responsible  for  some  of  the  careless  thinking  which 
tends  to  befog  an  already  difficult  subject. 

Going  value  in  the  monopolistic  and  regulative  field 
corresponds  to  good  will  in  the  competitive  field.  Going 
value  is  the  enhancement  in  the  value  of  the  physical  prop- 
erty of  a  pubHc  utility  due  to  the  business  that  the  concern  has 
or  is  doing. 

A  brief  consideration  of  the  ethical  difl'erences  between 
rate  and  purchase  cases  will  help  to  guide  the  appraiser  to 
a  clear  and  fair  appraisal  basis  of  going  value  for  these  two 
purposes. 

For  the  greater  part,  utilities  must  pass  through  an 
experimental  stage,  which  stage  is  an  expensive  one.  A 
property  which  has  passed  through  the  unfavorable  periods 
of  its  existence,  and  has  gained  its  balance  is  unquestionably 
worth  more  to  the  buyer  than  the  one  which  has  yet  to  pass 
through  such  experience  and  establish  itself.  The  careful 
purchaser  is  willing  to  forego  the  possibilities  of  greater 
returns  from  an  uncertain  property,  for  the  steady  certain 
income  of  an  established  business.  It  is  undeniably  true 
that,  in  a  purchase  case,  the  property  is  worth  more  because 
of  the  fact  that  it  is  established  and  earning  a  fair  return, 
than  one  which  is  not  so  fortunate.  In  purchase  cases,  there 
is  clearly  an  element  of  going  value  to  be  considered  in  the 
ascertainment  of  the  fair  present  value.  The  intangible 
property  in  such  cases  consists  of  a  value  inherent  in  the 
utility  due  to  the  fact  that  the  plant  is  enlivened  by  successful 
operation  and  hence  is  more  valuable  than  the  bare  bones 
of  the  physical  property.  It  is  well  to  recognize  that  value 
is  given  to  a  property  either  by  reason  of  the  fact  that  it 
is  an  instrument  for  earning  profit,  or  that  it  does  earn 
profit,  or  gives  promise  of  profit.  The  actual  investment 
of  capital  in  a  new  plant  is  made  with  the  expectation  of 
earnings.  In  fact,  in  an  established  business,  in  a  purchase 
ca-se,  going  value  is  measured  by  the  extent  of  these  earnings. 

For  rate  purposes,  however,  the  vital  question  is  not  the 
return  that  the  property  is  capable  of  earning  but  the  actual 
investment  in  the  property  used  and  useful  in  serving  the 


public.  In  purchase  cases  the  important  consideration  in 
evaluating  going  value  is  the  earning  capacity  of  the  utility. 
In  a  rate  case,  on  the  other  hand,  the  best  guidance  in  all 
controversial  points  is  an  ethical  consideration  of  the  actual 
sacrifices  of  the  investors,  that  is,  by  the  investment  in  the 
utility.  Unfortunately  the  investment  can  rarely  be  deter- 
mined. 

The  fundamental  basis  in  a  rate  case  is  comparatively  a 
simple  one.  The  public  is  entitled  to  efiicient  service  at 
reasonable  rates.  The  utility,  on  the  other  hand,  is  entitled 
to  a  fair  return  upon  the  investment  or  upon  the  actual 
value  of  the  property  used  and  useful  in  serving  the  public. 
To  base  any  estimates  of  value  in  rate  cases  upon  earnings 
is  to  argue  in  a  vicious  circle. 

We  are  not  so  much  concerned  with  the  methods  employed 
in  evaluating  going  value  as  we  are  in  the  underlying  prin- 
ciples involved.  Going  value,  no  matter  how  measured, 
whether  as  the  cost  of  developing  an  income  as  gauged  by 
the  early  losses,  or  calculated  upon  a  comparative  basis, 
or  upon  hypothetical  assumptions,  or  by  any  other  method, 
is  not  a  legitimate,  fair,  or  reasonable  addition  in  the  ascer- 
tainment of  fair  value  for  rate  purposes,  going  value  being 
a  function  of  earnings,  which  are  the  backbone  of  the  rate 
case  and  upon  which  the  entire  rate  case  is  centered.  Going 
value  should,  however,  receive  consideration  in  purchase 
cases. 

It  is  an  open  question  whether  equity  and  justice  require 
the  inclusion  of  any  going  value  where  there  is  no  evidence  of 
an  actual  sacrifice  incurred  by  the  owners  in  developing  the 
business.  All  arguments  in  favor  of  going  value  are  clearly 
applicable  to  purchase  cases.  It  is  believed  that  it  would 
be  equitable  and  fair  to  the  parties  involved  in  an  appraisal 
if  all  considerations  of  going  value  were  left  for  purchase 
cases,  and  only  those  elements  of  intangible  capital  which 
are  clearly  involved  in  the  cost  of  constructing  and  acquiring 
the  physical  property  were  included  in  the  present  value 
for  rate  purposes. 

Two  arguments  may  be  urged  for  including  going  value 
in  a  rate  case.  The  first  of  these,  the  early  losses  suffered 
during  the  first  years  of  operation,  has  no  force  unless  a 
satisfactory  audit  and  study  of  the  history,  quality  of  service, 
and  the  management  of  the  company  are  possible.  These 
facts  are  absolutely  essential  in  order  to  assure  the  existence 
of  such  losses,  and  further,  that  these  losses  have  not  already 
been  compensated  for. 

Nor  can  it  be  urged  that  an  allowance  for  going  value  is 
essential  in  order  that  cognizance  may  be  taken  of  efficiency  in 
management,  for  the  best  legitimate  reward  and  encourage- 
ment for  efficient  and  successful  management  in  this  com- 
mercial age  is  high  salaries,  and  not  an  allowance  for  going 
value  to  the  corporate  owners. 


GOING      V  A  L  U  E 


155 


DISCUSSION 

By  William  J.  Hagknah 

Public  Utility  Statistician,  Chicago,  Illinois 


I  have  listened  with  a  great  deal  of  interest  to  the  paper 
read  by  Mr.  Thorne.  He  has  had  so  wide  an  experience  in 
the  field  of  corporation  regulation  that  any  expression  from 
him  on  this  subject  must  be  based  not  only  on  the  results  of 
academic  study,  but  also  on  his  personal  knowledge  of  many 
corporations  operating  under  greatly  varying  conditions. 
The  paper  is  also  important  because  of  the  official  position 
of  its  author.  Mr.  Thorne  concludes,  if  I  understand  him 
correctly,  that  going  value  is  a  property  right  and  must  be 
recognized  in  rate  cases,  and  he  would  arrive  at  the  measure 
of  such  value  by  a  study  of  the  operating  records  of  the  com- 
pany to  show  the  losses  which  were  sustained  in  building  up 
the  business,  such  losses,  however,  to  be  confined  to  the 
early  years  of  the  venture. 

In  so  far  as  Mr.  Thorne  has  stated  the  justice  and  neces- 
sity of  an  allowance  for  going  value,  I  am  entirely  in  accord 
with  him.  I  believe  that  such  an  allowance  is  necessary  in 
most  cases  and  that  equity  alone,  if  no  other  conditions  were 
present,  would  require  such  provision.  I  also  agree  with  him 
as  t©  the  course  of  analytical  study  to  be  pursued  in  arriving 
at  the  measure  of  such  an  allowance  where  the  books  are 
available.  I  do  not  agree  with  him  in  the  conclusion  that 
the  allowance  for  going  value  as  determined  from  a  study  of 
the  books  and  records  should  be  confined  to  what  the  facts 
show  during  only  the  early  and  necessarily  experimental 
years  of  a  company's  business.  A  study  of  the  conditions 
which  have  prevailed  in  most  of  our  large  cities  will  show 
that  this  view  of  going  value  is  entirely  too  narrow  and  to 
adopt  Mr.  Thome's  conclusion,  as  a  general  rule,  would  be 
unwarranted  and  unfortunate  from  the  standpoint  of  both 
the  public  and  the  investors  in  each  case.  I  believe  that  all 
the  conditions  which  have  affected  the  company's  invest- 
ment and  operations  should  be  carefully  analyzed  and  from 
such  a  record,  in  which  the  factors  which  have  played  an 
important  part  in  the  upbuilding  of  the  particular  company 
are  shown  in  their  true  proportion,  a  commission  should  ar- 
rive at  what  is  proper  in  each  case,  giving  to  each  fact  and 
item  of  cost  such  weight  as  from  a  study  of  the  problem  in  its 
entirety  seems  just.  While  there  are  instances  where  the 
application  of  Mr.  Thome's  conclusion  would  work  no  in- 
justice, in  the  great  majority  of  cases  the  losses  which  have 
been  the  most  expensive  and  the  most  discouraging  have  come 
long  after  the  initial  operating  period.  The  time  as  to  which 
the  loss  occurred  is  not  so  important  as  the  character  of  such 
loss.  Each  case  should  be  decided  on  its  own  merits  after 
a  study  of  all  the  facts. 

There  are  two  general  reasons  making  it  necessary  to 
recognize  going  value.  First,  because  of  the  nature  of  a 
public  utility,  and  secondly,  because  of  the  economic  forces 
which  are  at  work  in  this  field.  To  base  the  return  to  the  in- 
vestors on  the  appraised  value  of  the  physical  plant  alone 
would  for  these  reasons  be  clearly  unjust  in  a  great  many  cases. 
The  public  utility  is  a  monopoly  and  subject  to  public  regula- 


tion. It  is  limited  to  a  reasonable  return  on  the  fair  value 
of  its  property.  It  is  compelled  at  all  times  to  give  adequate 
and  efficient  service  and  to  make  extensions  to  its  plant  even 
though  such  extensions  will  not  be  immediately  remunerative. 
The  issuance  of  its  securities  is  likewise  subject  to  public 
approval.  An  investment  once  made  is  fixed  for  all  time 
and  there  is  no  industry,  the  success  or  failure  of  which  is 
more  inseparably  connected  with  the  growth  or  decline  of 
the  community  served.  For  the  right  to  regulate  such 
properties,  the  public  should  recognize  the  obligation  to 
protect  them.  If  the  utility  is  at  all  times  limited  to  a 
reasonable  return,  it  will  never  be  able  to  overcome  un- 
avoidable losses  unless  they  are  considered  in  some  form  of 
going  value,  and  this  is  true  whether  such  losses  were  incurred 
in  its  second  year  or  twentieth  year  of  operation.  The  test 
is  whether  such  loss  had  to  be  assumed  by  the  company  in 
the  course  of  its  duty  to  stand  by  its  service  obligations  to 
the  public.  If  it  was  so  incurred,  the  public  at  this  time 
cannot  justly  ask  the  stockholder  to  bear  all  of  such  loss. 

Further,  we  are  living  in  an  age  of  great  increases  in  the 
volume  of  gold,  which  results  in  a  great  increase  in  the 
general  level  of  prices.  Every  year  and  almost  every  month 
the  index  figures  show  new  high  records  for  commodity 
prices.  Certain  classes  of  construction  and  operating  supplies 
have  increased  in  cost  from  20  per  cent  to  60  per  cent  since 
1895  and  these  price  advances  have  been  equalled  in  the  rise 
in  wages  for  many  classes  of  labor.  These  advancing  levels 
have  inaugurated  a  period  of  great  public  and  private  extrava- 
gance. Our  cities  have  grown  more  rapidly  during  the  last 
twenty  years  than  at  any  other  time  in  the  country's  his- 
tory. City  debts  have  doubled  and  trebled  and  in  some 
cases  increased  nearly  fivefold.  Former  sources  of  municipal 
revenue  have  been  proved  inadequate  and  new  sources  have 
been  found  necessary.  Old  forms  of  taxes  have  been  in- 
creased and  new  assessments  are  frequently  made  and 
variously  called  street  maintenance  taxes,  paving  taxes, 
franchise  taxes,  gross  earnings  taxes,  etc.  Private  industries 
are  able  to  shift  such  taxes  and  also  the  rise  in  prices  and 
wages,  but  utilities  cannot  do  so.  They  are  ground  between 
the  upper  stone  of  advancing  commodity  prices  and  wages 
and  the  nether  stone  of  the  depreciating  purchasing  power 
of  their  dollar  of  income.  It  requires  no  prophet  to  see  that 
the  time  is  coming  when  many  of  our  utilities  will  be  seeking 
relief  from  legislative  bodies  because  of  these  economic  forces 
which  are  so  relentlessly  at  work.  These  are  factors  which 
you  must  consider  in  some  form  when  you  discuss  rate  making 
bases  and  not  confine  your  analysis  to  present-day  reproduc- 
tion costs  and  actual  cash  investments.  They  may  well  be 
considered  as  having  a  bearing  on  the  allowance  for  going 
value. 

I  think  Mr.  Thorne  ridiculed  in  general  the  idea  of  losses 
measuring  the  going  value  of  a  business.  He  is  right,  if  we 
accept  his  limited  definition  of  going  value.     Of  course. 


156 


THE      UTILITIES      MAGAZINE 


losses  do  not  make  value.  They  do,  however,  measure  costs, 
and  where  such  losses  were  unavoidable  and  were  incurred 
in  the  carrying  out  of  the  company's  business  obligations 
they  are  costs  which  commissions  should  consider  in  arriving 
at  fair  rate  making  bases.  I  will  not  quarrel  as  to  terminol- 
ogy. We  may  call  this  subject  "going  value,"  "going  cost" 
or  "cost  of" establishing  the  business,"  but  in  the  broad  view 
of  public  utility  regulation  we  are  talking  pretty  much  about 
the  same  thing,  which  is,  that  element  of  value  over  and 
above  the  appraised  physical  plant  alone.  Accepting  the 
broadest  definition,  the  allowance  for  going  value  may 
be  predicated  on  past  losses  or  costs,  or  it  may  even  be  a 
recognition  of  the  efficiency  and  skill  of  the  management  in 
having  avoided  losses  as  compared  with  another  company 
not  so  fortunate. 

The  limitation  of  going  value  to  the  early  years  of  each 
company  is  wrong  in  principle  and  contrary  to  fact.  In  the 
first  place,  the  losses  incurred  in  the  early  years  by  many  of 
the  companies,  when  expressed  in  terms  of  present  day  in- 
vestments in  those  same  properties,  are  almost  negligible. 
The  real  losses  as  a  rule  occur  at  a  much  later  date.  The 
Chicago  Telephone  Company  has  a  present  investment  of 
over  $55,000,000.  After  six  years  of  operation  its  investment 
was  less  than  $700,000.  If  all  this  were  called  going  value, 
it  would  be  only  1§  per  cent  of  the  present  investment.  As 
late  as  1894  the  total  investment  in  the  Cleveland  electric 
properties  was  only  about  3  per  cent  of  the  present  investment. 
The  Portland  Railway,  Light  &  Power  Company  has  a 
present  value  of  over  $50,000,000.  Its  investment  after 
six  years  of  operation  was  only  $2,600,000,  and  yet  its  records 
show  that  it  has  failed  to  earn  an  average  annual  reasonable 
return  by  over  $5,000,000.  There  are  some  companies  which 
may  receive  all  they  are  justly  entitled  to  under  Mr.  Thome's 
rule,  but  in  most  cases,  especially  in  our  large  cities,  his  rule 
would  not  meet  the  situation. 

I  can  see  three  distinct  and,  to  my  mind,  powerful  reasons 
why  the  study  of  the  going  value  should  be  extended  over  the 
entire  history  of  the  company  under  investigation.  First, 
the  tremendous  and  continuing  growth  of  many  of  our  cities 
has  made  it  impossible  for  the  many  utilities  in  such  centers 
to  earn  a  reasonable  return  on  their  true  investment. 
Lengthy  extensions  of  street  railways,  gas  mains,  or  pole 
lines  have  been  made  necessary  by  public  sentiment  far  in 
advance  of  actual  needs  or  promise  of  early  profit. 

Go  to  the  outskirts  or  suburban  territory  of  any  large  city 
and  you  will  see  going  value  in  the  making.  You  will  find 
many  miles  of  utility  lines  with  very  few  customers  per  unit 
of  investment,  but  this  same  investment  is  bringing  people 
out  of  the  tenement  districts  to  homes  where  light,  air  and 
gardens  are  possible.  When  this  territory  fills  up  to  a 
profitable  basis,  the  lines  will  long  since  have  been  extended 
into  other  and  still  newer  fields.  The  sociological  benefits 
resulting  from  such  extensions  deserve  some  recognition, 
especially  when  it  is  remembered  that  it  costs  the  city 
nothing  to  order  such  extensions. 

In  many  cases  these  plant  extensions  have  represented 
nearly  a  total  loss,  failing  to  earn  even  maintenance  and 


depreciation  charges  for  a  number  of  years,  which  loss  must 
be  deducted  from  the  earnings  of  the  more  profitable  lines 
to  the  extent  that  no  real  profit  was  possible  on  the  business 
as  a  whole.  I  know  of  one  company  with  a  cash  investment 
in  physical  plant  of  $39,000,000  made  over  a  period  of  twenty- 
five  years,  but  of  this  amount  $26,000,000  was  invested  in 
additions  during  the  last  eight  years,  and  in  spite  of  the  great 
growth  of  the  business  It  cannot  earn  an  average  of  6  per  cent 
on  its  actual  cash  investment. 

Consider  such  cities  as  Los  Angeles,  Portland,  Seattle, 
Spokane  and  Denver,  where  the  population  has  on  an  average 
doubled  every  ten  years  during  the  last  thirty  years.  Seattle 
and  Portland  each  have  a  city  area  as  large  as  Detroit  and 
Baltimore  combined,  but  a  population  less  than  half  of 
either  of  such  eastern  cities.  Their  service  development  is  as 
good  as  that  In  the  eastern  cities  but  they  have  far  less 
traffic  to  support  It.  Also,  they  have  no  slum  districts  and 
no  congestion  of  population  In  any  form.  I  might  mention 
more  Instances,  and  some  here  in  the  East,  but  time  forbids. 
What  I  have  called  attention  to,  however,  should  show  the 
error  of  limiting  the  going  value  period  to  an  arbitrary  num- 
ber of  years. 

Again,  consider  the  enormous  losses  classified  as  deprecia- 
tion resulting  from  Inadequacy,  obsolescence,  progress  in  the 
art,  etc.  These  losses  never  made  themselves  felt  in  the 
early  years  of  the  utility.  I  remember  as  a  child  visiting 
what  was  then  called  one  of  the  largest  central  stations  in  the 
world.  Its  dimensions  were  not  over  thirty  feet  square. 
AH  Its  machinery  would  not  fill  one  modern  auto-truck. 
Now  recall  the  plants  of  fifteen  years  ago  with  their  crude 
and  clumsy  machinery  and  lines  of  wire  which  darkened  the 
principal  business  streets.  Consider  also  the  telephone 
equipment  and  the  type  of  street  cars  of  that  day.  The 
mighty  changes  which  have  occurred  help  to  spell  going  value 
in  many  cases.  If  the  cost  of  such  changes  has  been  amor- 
tized, by  subsequent  profits,  well  and  good.  When  they 
have  not  been  amortized,  should  not  the  public  rightfully 
regard  some  fair  portion  of  such  losses  as  a  part  of  the  cost 
of  building  up  the  present  highly  efficient  utility  plants? 

Nor  Is  that  all.  Stop  and  consider  the  tremendous  losses 
which  competition  has  occasioned.  The  right  to  regulate 
should  carry  with  it  a  duty  to  protect.  Yet  In  many  of  our 
cities,  as  soon  as  a  utility  was  firmly  estabUshed  and  its  busi- 
ness showing  profits  a  competing  company  was  enfranchised, 
streets  were  torn  up  and  rate  wars  ensued  until  one  company 
purchased  the  other.  This  settlement  Invariably  loaded 
some  purely  duplicate  property  onto  the  remaining  com- 
pany, which  property  was  a  complete  loss,  as  well  as  the 
earnings  lost  In  the  rate  wars.  This  happened  not  once  but 
many  times  in  most  of  our  large  cities.  Where  a  present 
utility  is  the  outgrowth  of  a  merger  of  a  number  of  plants,  of 
which  one  of  such  companies  will  the  going  value  analysis 
be  made  under  Mr.  Thome's  rule?  The  Chicago  gas  utility 
is  the  result  of  a  combination  of  seven  companies  and  In  some 
cases  there  are  over  a  dozen  gas  mains  in  a  single  street  in  that 
city.  Detroit  has  had  four  competing  telephone  systems 
and  there  Is  enough  telephone  duct  in  some  streets  to  meet 


GOING      VALUE 


157 


every  future  demand  which  can  now  be  anticipated.  This 
condition  is  even  more  marked  in  Portland,  where  there 
have  been  over  fifty  separate  electric  lighting  and  street 
railway  companies,  and  only  in  1911  was  another  constructed 
with  an  investment  of  over  $8,000,000.  These  dupUcate 
plants  were  not  needed,  for  adequate  service  was  being 
supplied  by  the  existing  company.  When  pubUc  sentiment 
demands  competition,  which  is  contrary  to  every  idea  of  a 
natural  monopoly  and  public  regulation,  it  would  seem  but 
a  matter  of  simple  justice  that  some  weight  should  be  given 
in  rate  cases  to  losses  which  have  been  occasioned  in  this 
manner. 

Closely  allied  to  this  subject  are  the  losses  due  to  consoli- 
dation of  the  individual  plants  in  many  cities  into  one  great 
well-balanced  operating  company.  In  hundreds  of  in- 
stances in  this  country  the  electric  plants  operating  in  small 
cities  were  giving  service  only  during  the  hours  of  darkness. 
Wires  in  certain  streets  were  often  attached  to  trees  and  every 
storm  interrupted  the  service.  These  plants  are  rapidly 
being  dismantled  and  replaced  by  modern  distribution 
systems  supplied  from  high  tension  transmission  lines  leading 
from  large  and  economical  central  stations.  As  instances  of 
this  kind  I  need  only  mention  the  Pacific  Gas  and  Electric 
Company,  The  Montana  Power  Company,  the  Pacific 
Power  &  Light  Company  and  the  Texas  Power  &  Light 
Company.  Some  of  these  companies  serve  from  fifty  to  over 
a  hundred  separate  cities  and  villages.  To  limit  the  deter- 
mination of  going  value  to  the  initial  years  of  each  company 
in  each  separate  city  means  little  in  these  cases.  It  is  al- 
together impracticable.  Mr.  Thome's  rule  does  not  fit  the 
facts  as  they  exist  today. 

When  Mr.  Thorne  criticizes  some  of  the  claims  for  going 
value  I  am  inclined  to  agree  with  him.  There  have  been  much 
loose  thinking  and  still  more  loose  testifying  on  this  subject. 
But  I  do  not  believe  that  this  condition  is  an  argument  against 
an  exhaustive  study  of  the  subject  in  order  that  we  may  arrive 
at  our  conclusions  from  a  proper  understanding  of  the  entire 
problem.  I  think  corporations  have  overlooked  the  neces- 
sity for  more  facts  and  less  general  assertions  in  dealing  with 
this  item  of  value.  I  have  no  sympathy  with  the  engineer 
who  counts  every  pole,  cross  arm  and  insulator,  every  bolt 
and  board,  studies  soil  conditions,  freight  rates  and  accident 
insurance  rates  and  then  adds  in  a  more  or  less  arbitrary 
manner  5  per  cent  for  engineering,  6  per  cent  for  interest, 
5  per  cent  for  contingencies,  3  per  cent  for  insurance  and 
taxes,  etc.,  and  then  another  15,  20  or  even  30  per  cent  for 
going  value.  That  is  not  making  a  fair  appraisal.  We 
might  as  well,  if  we  wished  the  measure  of  a  hundred  yards, 
mark  off  the  first  fifty  yards  with  a  temperature  adjusted 
steel  tape  and  then  pace  the  rest.  When  a  subject  is  difficult 
of  accurate  determination,  it  calls  for  all  the  more  study. 
If  a  company  is  entitled  to  going  value,  it  can  generally  prove 
that  fact  by  evidence  satisfactory  to  a  court  or  commission. 

I  do  not  altogether  agree  with  Mr.  Thorne  in  his  conclu- 
sions regarding  appraisal  engineers.  My  own  experience 
has  given  me  a  different  impression.  That  there  have  been 
and  still  are  some  exceedingly  Hberal  estimators  is  of  course 


true.  It  is  an  easy  matter  to  make  a  claim,  and  that  applies 
to  both  corporations  and  cities.  That  condition,  however, 
is  true  of  every  profession,  even  among  lawyers.  I  have  repre- 
sented both  cities  and  corporations  in  many  rate  cases  in 
every  part  of  the  United  States,  and  I  find  that  it  is  seldom 
that  a  physical  appraisal  varies  over  10  per  cent.  Five 
per  cent  differences  are  not  uncommon  and  I  recall  one  case 
where  in  an  appraisal  of  over  $5,000,000  the  difference  be- 
tween the  parties  was  less  than  one  half  of  1  per  cent.  I 
think  we  should  hear  more  of  the  successful  appraisals  and 
less  of  the  extremes,  or  at  least  not  base  a  general  rule  on  the 
extreme  cases.  An  analysis  of  such  cases  will  generally  show 
that  the  wide  difference  is  confined  to  one  or  two  items,  which 
one  side  may  disallow  altogether  and  for  reasons  open  to 
argument  and  possibly  calling  for  judicial  determination. 
We  are  also  learning  more  each  year  about  making  appraisals 
and  that  helps  to  eliminate  the  extremists. 

As  I  listened  to  the  papers  of  yesterday  and  today  I  rather 
gathered  the  impression  that  it  was  easy  for  us  to  become  too 
academic  and  that  in  our  search  for  absolute  accuracy  in 
small  details  we  might  lose  sight  of  our  real  objective, — 
fair  value  and  reasonable  returns.  We  are  all  pretty  well 
agreed  as  to  general  principles.  The  bigger  problem  is  the 
application  of  such  principles  to  the  facts  and  difficulties  as 
they  arise  in  each  case.  The  law  on  this  subject  is  fairly 
well  settled  and  each  year  sees  more  difficulties  cleared  away. 
The  legislatures  have  expressed  the  policy  of  the  several 
states  with  respect  to  public  utilities  and  have  created  legis- 
lative bodies  or  commissions  to  carry  out  these  policies. 
Throughout  the  statutes  and  the  decisions  we  see  instructions 
and  duties  which  can  be  dischargejl  only  through  the  exercise 
of  a  broad  judgment  expressed  in  a  spirit  of  fairness  and  predi- 
cated on  a  record  showing  all  the  facts  which  it  is  possible  to 
produce.  Some  of  the  items  under  discussion  here  and  on 
which  opinions  vary  widely  are  of  such  slight  consequence  in 
their  practical  application  as  to  be  without  material  effect 
on  the  question  of  fair  value  and  reasonable  rates. 

Rate  making  is  far  from  being  an  exact  science.  If  regu- 
lation and  the  finding  of  fair  value  involved  nothing  but 
engineering  work,  the  commissions  should  consist  only  of 
construction  engineers.  If  the  work  involved  only  balance 
sheets  and  profit  and  loss  statements  with  no  right  to  elimi- 
nate items  or  to  make  adjustments,  the  commission  should 
be  made  up  of  certified  public  accountants.  If  this  work 
called  for  only  the  listing  of  items  and  the  appHcation  of 
percentages,  the  commissions  might  be  made  up  of  men  who 
are  experts  on  the  adding  machine  and  clever  with  their 
pencils.  But  regulation  means  more  than  this.  It  requires 
not  only  engineering  and  accounting  skill,  but  a  knowledge 
of  political  economy  as  well,  ability  to  correlate  all  the  facts 
and  to  harmonize  the  various  forces,  to  see  in  each  case  some- 
thing of  the  history  of  the  public  utility  business,  an  appre- 
ciation of  its  present  position  and  its  future  prospects,  and 
from  the  evidence  showing  the  facts  with  respect  to  each 
point  as  clearly  as  it  is  possible  to  do  so,  to  form  a  judicial 
opinion  as  to  what  is  just  and  proper  in  the  premises  today. 
The  fair  value  so  determined  may  be  greater  or  less  than  the 
engineers'  reproduction  cost  and  depreciated  value  estimates. 


158 


THE      UTILITIES      MAGAZINE 


it  may  be  greater  or  less  than  the  accountants'  conclusion  as 
to  the  actual  cash  cost,  and  it  may  or  may  not  contain  a 
substantial  allowance  for  going  value.  It  will,  however, 
contain  a  recognition  for  every  element  of  value  which  can 
be  shown  to  be  proper  and  that  will  include  going  value. 


based  not  on  assumptions  nor  computed  over  an  arbitrarily 
limited  period  of  time,  but  rather  on  all  the  facts  as  they  have 
actually  influenced  the  operations  of  each  specific  company 
and  in  the  measure  which  today  seems  equitable  to  both  the 
public  and  the  investors. 


OPEN  DISCUSSION 


Mr.  Thokne: 

I  have  a  page  here,  copied  from  a  report  of  the  Wisconsin 
Commission,  which  shows  the  Superior  Water,  Gas  &  Electric 
Company  earned  in  1890  1.7  per  cent;  1896,  2  per  cent;  1897 
less  than  2  per  cent;  1898, 5  per  cent,  and  the  next  two  years 
a  total  deficit.  Did  regulation  have  anything  to  do  with 
this  deficit? 

Mr.  Hagenah: 

I  don't  think  that  regulation  caused  the  deficiency.  I 
think  that  regulation  gave  a  greater  stability  to  this  plant 
than  it  ever  had  before.  Wisconsin  began  the  regulation  of 
utilities  in  1907. 

Mb.  Thokne: 

So  that  it  did  not  have  anything  to  do  with  those  deficits 
back  of  1907,  did  it? 

Me.  Hagenah: 

Regulation  never  caused  the  deficits. 

Mb.  Thorne: 

And  yet  you  desire  the  authority  to  make  good  those 
previous  losses? 

Mb.  Hagenah: 

In  the  case  of  Superior  and  Duluth,  I  think  it  entirely 
proper  that  a  public  service  commission  should  consider 
the  conditions  which  have  prevailed  in  those  cities  and 
which  doubtless  account  for  the  deficits  which  you  mention. 
I  am  sure  you  know  that  Duluth  and  Superior  were  the 
centers  of  a  great  boom  about  twenty-five  years  ago.  Con- 
struction and  improvements  had  been  made  anticipating  a 
city  of  100,000  population.  This  boom  collapsed  and  for 
eight  or  nine  years  these  cities  were  as  depressed  as  it  is  pos- 
sible to  imagine.  The  population  decreased  decidedly  and 
many  business  establishments,  both  large  and  small,  removed 
from  these  cities  entirely.  Duluth  and  Superior  are  now 
prosperous  cities  with  an  aggregate  population  of  approxi- 
mately 150,000.  Their  industries  are  prosperous  and  are 
growing  rapidly.  Since  the  public  utilities  represent  fixed 
investments  and  could  not  shift  to  meet  the  depressed  condi- 
tions as  private  concerns  did,  I  think  that  now  in  the  pros- 
perous days  of  these  cities,  the  public  can  well  afford  to  make 
some  provision  for  the  losses  which  the  utilities  sustained. 
It  might  not  be  fair  to  provide  for  the  entire  losses,  but  I  do 
think  that  in  making  the  appraisals  for  rate  making  purposes 
some  allowance  should  be  made  for  the  losses  which  the 


utilities  could  not  avoid  and  which  to  a  large  extent  individ- 
uals and  private  enterprises  were  able  to  avoid. 

Large  profits  were  made  out  of  real  estate  during  the  boom 
years  and  the  value  which  was  created  in  lots  then  sold  was 
in  large  part  due  to  the  many  miles  of  public  utility  facilities 
which  were  constructed.  The  profit  resulting  to  the  land 
owners  was  such  that  I  believe  they  could  well  afford  to  give 
some  consideration  to  the  interests  of  the  utility. 

Mb.  Thorne: 

The  people  who  lost  money  during  this  time  of  course  will 
not  be  protected  by  the  public.  Neither  are  all  the  people 
in  Duluth  and  Superior  fortunate  enough  to  be  land  owners. 

Mr.  Hagenah: 

What  you  say  is  true.  In  the  adjustment  of  conditions, 
some  classes  may  in  the  first  instance  be  much  more  fortu- 
nate, but  those  matters  generally  adjust  themselves  in  the 
course  of  a  few  years  when  prosperity  becomes  to  some 
extent  distributed. 

Robert  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 
versity: 

Mr.  Hagenah  implied  that  the  people  who  would  benefit  in 
the  city  of  Superior  by  the  reduction  of  rates  are  all  of  them 
land  owners  who  have  received  unearned  increments.  Is  he 
not  aware  of  the  fact  that  probably  a  large  majority  of  the 
people  in  any  large  city  are  not  owners  of  property  and  have 
not  benefited  by  the  increased  realty  values? 

Mr.  Hagenah: 

You  are  correct  in  stating  that  many  of  the  people  do  not 
own  property,  but  I  believe  that  on  a  return  of  prosperous 
conditions  their  interests  are  benefited  as  well  as  those  of 
the  land  owners.  We  could  discuss  this  for  a  long  time  in 
an  academic  way.  From  a  practical  standpoint  a  fair 
provision  for  the  losses  incurred  would  probably  not  be  a 
burden  to  any  one.  All  I  am  arguing  for  is  that  we  cease  to 
take  a  narrow  and  restricted  view  of  utilities  and  of  going 
value.  I  think  we  should  pay  more  attention  to  the  practi- 
cal conditions  as  they  are  found  in  an  analysis  of  the  prop- 
erties themselves  and  the  conditions  under  which  they  were 
developed. 

John  Bauer,  Assistant  Professor  of  Economics,  Cornell 
University: 

Mr.   Hagenah   has   presented    an   interesting   and  fluent 
defense  of  the  idea  that  past  deficiencies  in  return  should 


GOING      VALUE 


159 


properly  be  included  in  a  rate  valuation  under  the  general 
caption  of  going  value.  His  view  is  in  harmony  with  the  law 
in  the  State  of  New  York  as  interpreted  by  the  Court  of 
Appeals  in  the  Kings  County  Lighting  case,  and  agrees  with 
the  practice  of  the  Wisconsin  Railroad  Commission  as 
presented  in  the  Antigo  Water  case.  He  would  include  under 
going  value  not  only  actual  developmental  costs,  but  all 
past  expenses  and  losses  that  do  not  appear  in  the  tangible 
and  overhead  values  or  have  not  been  returned  to  the  invest- 
ors in  some  definite  form. 

There  is,  of  course,  a  great  deal  to  be  said  for  the  view  that 
Mr.  Hagenah  presents,  and  it  is  precisely  the  kind  of  consid- 
erations that  he  has  briefly  outlined  that  swayed  the  Court  of 
Appeals  of  the  State  of  New  York  to  give  going  value  the 
very  broad  meaning  which  includes  the  capitalization  of  all 
past  deficiencies  in  return.  The  cases  that  Mr.  Hagenah 
mentions  of  investors  incurring  heavy  losses  on  account  of 
competition,  changing  population,  shifting  requirements  of 
service,  etc.,  may  be  easily  duplicated  in  every  part  of  the 
country.  Undoubtedly,  if  opportunity  in  such  cases  is  not 
given  to  the  investors  to  recoup  their  losses  through  service 
rates  in  the  future,  some  personal  injustice  or  hardship  will 
be  inflicted. 

But,  it  seems  to  me,  while  I  have  a  great  deal  of  sympathy 
with  the  view  that  Mr.  Hagenah  presents,  it  cannot  be  satis- 
factorily applied  throughout  to  all  cases.  Our  standards  of 
valuation  must,  of  course,  be  based  on  justice,  but  we  must 
consider  the  matter  from  a  broad  standpoint,  or  otherwise 
we  shall  not  get  very  far  in  the  regulation  that  we  desire. 
Considerations  of  minute  personal  justice  must  not  blind  us 
to  the  requirements  of  broad  policy  which  will  conserve  and 
promote  the  general  welfare   in  the  future. 

As  I  attempted  to  bring  out  in  my  discussion  in  connection 
with  depreciation  as  related  to  fair  value,  it  seems  to  me,  to 
repeat  briefly,  what  we  should  do  is  to  decide  upon  a  definite 
and  practically  automatic  policy  of  regulation  of  return.  For 
the  future,  we  should  allow  a  fair  return  on  actual  investment, 
and  no  more,  and  we  should  make  the  provisions  so  definite 
that  the  investors  would  know  exactly  the  risk  that  they  incur 
and  the  conditions  of  the  return  that  they  may  receive. 
But,  as  to  existing  investments,  it  must  be  admitted,  we  are 
in  a  hopeless  muddle  if  we  are  too  minutely  concerned  with 
personal  justice.  In  most  cases  the  records  of  the  past  are 
untrustworthy.  We  cannot  determine  neither  the  approxi- 
mate actual  investment,  nor  the  returns  already  realized. 
Further,  it  must  be  remembered,  while  all  the  time  we  have 
had  the  right  to  regulate,  we  have  not  exercised  the  right  but 
have  given  practically  a  free  chance  to  the  companies  to  earn 
all  the  profits  that  they  could.  Rates  have  been  based  not 
on  cost,  but  on  what  the  traffic  would  bear.  Many  companies 
have  made  hugely  excessive  returns  (witness  the  fortunes  that 
have  been  made  out  of  public  utility  investments) ;  the  aver- 
age company,  we  may  reasonably  suppose,  has  been  moder- 
ately profitable;  but,  of  course,  many  companies  have  not 
earned  the  return  to  which  the  investors  were  fairly  entitled. 

Now  Mr.  Hagenah's  discussion  applies  simply  to  past 
unprofitable  ventures.  If  we  wish  to  establish  definite 
regulation  for  the  future,  to  get  anywhere  we  must  adopt  a 


reasonable  valuation  policy  as  to  existing  investments, — 
and  the  policy  should  not  be  complicated  by  too  many  con- 
siderations. The  difficulty  with  Mr.  Hagenah's  proposal  is, 
it  cannot  very  well  be  applied  logically  to  all  cases.  If  in  a 
valuation  we  are  to  make  additions  for  past  deficiencies  in 
return,  are  we  prepared  to  make  subtractions  for  past  exces- 
sive earnings?  Mr.  Hagenah,  in  general,  seems  to  have  in 
mind  as  a  basis  of  valuation  what  we  may  term  the  net 
sacrifice  to  investors.  In  a  sense,  this  basis  appears  as  most 
just,  but  I  feel  convinced  that  Mr.  Hagenah  is  not  prepared 
to  apply  it  rigorously  to  all  valuations  of  public  utility  in- 
vestments. 

If  we  were  to  apply  the  net  sacrifice  rule  throughout,  there 
would  be  many  cases  in  which  the  existing  investment 
would  be  entirely  wiped  out  through  past  excessive  earnings, 
and  there  would  be  some  cases  when  the  stockholders  would 
be  found  indebted  to  the  public  for  undue  profits  that  they 
received.  Practically  it  would  seem  quite  unworkable  to 
take  back  profits  obtained  under  rates  which  we  permitted  to 
exist.  Such  a  proposal  simply  would  not  work.  Neither 
the  New  York  nor  Wisconsin  rules  contemplate  that  there 
should  be  a  deduction  from  the  valuation  on  account  of  past 
earnings.  I  do  not  suppose  either  that  Mr.  Hagenah  would 
favor  such  a  deduction. 

What  the  idea,  therefore,  after  all  amounts  to  is,  we  should 
add  to  the  valuation  for  past  deficiencies  in  return,  but  not 
subtract  for  excessive  earnings.  In  other  words,  in  the  case 
of  past  unprofitable  undertakings,  we  should  follow  the  rule 
of  net  sacrifice  to  the  investors,  while  in  the  case  of  profitable 
enterprises,  we  should  make  a  physical  appraisal  and  base  the 
valuation  upon  the  cost  of  the  property  (with,  of  course, 
liberal  allowance  for  all  possible  overhead  items)!  Past 
losses  are  to  be  capitalized  against  the  future  service  of  the 
public,  but  past  undue  profits  are  to  be  disregarded!  The 
rule  works  only  against  the  public,  never  in  its  favor.  Does 
justice  work  only  the  one  way?  If  in  full  fairness  we  should 
capitalize  past  losses,  why  in  equal  justice  should  we  not 
deduct  from  the  physical  valuation  on  account  of  past  un- 
justifiable profits? 

But,  as  already  stated,  Mr.  Hagenah's  idea  of  going  value 
really  cannot  very  well  be  worked  both  ways.  For  this 
reason,  also  because  practically  all  companies  have  had  a 
free  chance  in  the  past  to  earn  all  the  profits  that  they  could, 
I  believe  it  would  be  highly  desirable  to  make  no  allowance  in 
a  valuation  for  past  losses, — to  disregard  entirely  the  ques- 
tion of  past  returns,  whether  profits  or  losses.  Everything 
considered,  the  simplest  and  all  around  the  fairest  policy  to 
pursue,  would  be  to  draw  a  curtain  on  the  past;  take  in  any 
case  the  existing  property;  value  it  on  a  reasonable  cost 
basis  with  due  allowance  for  depreciation;  place  the  valua- 
tion on  the  books  of  the  company;  for  the  future  allow  a 
reasonable  return  on  the  amount  and  no  more;  also  allow  a 
fair  return  and  no  more  on  all  additional  investments.  This 
procedure  would  permit  definite  regulation  of  return  for  the 
future;  investors  would  know  precisely  on  what  terms  they 
are  devoting  their  capital  to  the  public  service;  regulation 
would  become  practically  an  automatic  matter. 


160 


THE      UTILITIES      MAGAZINE 


Chables  W.  McKay,  Consulting  Engineer,  Chicago: 

In  his  discussion  of  the  paper  entitled,  "Going  Value  as  an 
Element  in  Fair  Value,"  Mr.  A.  M.  Fox  intimated  that  going 
value  occupies  much  the  same  position  with  respect  to  public 
utilities  that  good  will  does  to  privately  owned  competitive 
enterprises.  Mr.  Fox  is  not  alone  in  this  contention,  for  one 
frequently  hears  allusions  to  going  value  as  a  sort  of  pubUc 
utility  good  will. 

A  careful  analysis  of  the  defim'tions  and  usual  applications 
of  the  two  terms  raises  a  grave  question  as  to  the  propriety 
of  any  application  which  implies  that  they  are  even  remotely 
related. 

Going  value  has  been  variously  defined  as  "the  cost  of 
establishing  the  business,"  "the  cost  of  acquiring  an  income," 
and  "the  capitalization  of  early  losses  incurred  in  connection 
with  the  development  of  the  business  to  a  point  where  it  is 
capable  of  producing  a  return  on  the  investment." 

The  meaning  of  the  term  "good  will"  is  almost  self-evi- 
dent— it  is  "  the  probability  that  the  old  customers  will  con- 
tinue to  resort  to  the  old  place  of  business." 

Obviously  there  can  be  no  possible  similarity  between  the 
values  represented  by  these  two  terms,  granting  the  correct- 
ness of  the  foregoing  definitions.  It  may  be  even  possible 
for  a  utility  to  claim  both  a  going  value  and  a  value  for  good 
will. 

Assume,  for  instance,  that  case  of  two  competing  telephone 
companies  of  about  the  same  subscriber  development. 
Despite  the  fact  that  company  A  is  older  and  offers  superior 
advantages  in  the  way  of  toll  connections,  company  B,  by 
reason  of  its  efficient  management  and  high  standard  of  serv- 
ice, has  gained  in  popularity  until  its  subscriber  list  equals 
that  of  company  A,  and  its  prospects  for  future  development 
are  exceedingly  bright.  Obviously  a  prospective  buyer  for 
company  B  must  expect  to  pay  something  over  and  above 
the  rate  base  value  of  the  property,  including  going  value,  if 
he  expects  to  consummate  a  purchase. 

In  the  case  of  monopolistic  utilities,  however,  good  will  has 
not,  and  cannot  have,  a  place. 

Discrepancies  in  the  definition  and  appHcation  not  only 
of  such  terms  as  good  will  and  going  value,  but  even  of  the 
fundamentals  cost  and  value,  are  by  no  means  infrequent. 
A  paper  presented  before  the  Utilities  Bureau  on  November 
10th  was  entitled,  'Reproduction  Value  vs.  Fair  Value." 
The  term  reproduction  value  is  hardly  in  accordance  with  the 


precedent  established  by  courts,  commissions  and  recognized 
authorities  on  appraisal  matters.  From  the  text  of  the  paper 
it  is  evident  that  the  writer  seriously  questions  the  fairness 
of  rate  base  values  determined  by  the  reproduction  cost 
method.    The  title  of  the  paper,  however,  is  misleading. 

In  conclusion,  the  present  writer  takes  the  Uberty  of  urging 
the  adoption  of  clear,  concise  definitions  of  current  appraisal 
terms,  based  upon  established  precedent,  and  of  suggesting 
that  strict  adherence  to  such  definitions  would  facilitate  a 
clearer  understanding  of  a  subject  which,  at  best,  is  some- 
what illusive.  Inasmuch  as  the  conferences  held  under  the 
auspices  of  The  Utilities  Bureau  are  attended  by  prominent 
representatives  of  the  legal,  engineering,  and  accounting 
professions  and  by  members  of  the  various  state  commissions, 
a  committee  appointed  by  The  Utilities  Bureau  might  prove 
of  great  service  in  effecting  the  standardization  of  at  least 
the  fundamental  appraisal  terms. 

Mb.  Thoene: 

I  don't  know  what  is  the  custom  of  the  person  closing; 
I  will  say  just  a  word;  but  I  hope  Mr.  Erickson  is  now  in 
the  room.  I  have  the  highest  regard  for  the  Wisconsin 
Commission;  I  believe  the  Wisconsin  Commission  has  done 
the  country  a  great  service  in  challenging  attention  to  the 
historical  method  of  quoting  facts,  instead  of  leaving  this 
subject  to  a  lot  of  sweeping  generalities  and  fine-spun 
theories,  that  are  rife  for  a  time.  But  I  must  still  take  ex- 
ception to  the  position  taken  by  our  friend  Hagenah,  on  one 
proposition. 

I  have  at  no  time  said  that  I  believed  going  value  should 
be  allowed  for.  I  have  used  other  phrases;  because  going 
value  is  an  ambiguous  word.  It  means  many  different 
things.  One  state  commission  holds  it  means  all  intangible 
values.  One  commission  holds  it  means  the  same  thing  as 
good  will.  I  have  avoided  the  use  of  the  term  when  I 
wanted  to  commit  myself.  For  the  actual  costs  of  estabhsh- 
ing  the  business,  the  development  cost,  a  company  is  entitled 
to  some  consideration;  but  when  it  comes  to  the  state  going 
a  step  further,  when  it  comes  to  asking  the  state  to  capitalize 
the  losses  of  people  in  one  industry — losses  that  occurred 
10,  15,  or  50  years  before  regulation  was  ever  in  existence — 
I  think  it  is  utter  folly.  I  think  that  no  court  or  commission 
permanently  will  follow  that  course. 


UNIT      PRICES 


161 


THE  PROBLEM  OF  UNIT  PRICES  IN  VALUATION 

By   M.   G.   Glaeseb 

Statistician,  Wisconrin  RaOroad  Commission 


The  problem  of  unit  prices  is  basic  to  the  whole  problem 
of  valuation.  If  the  unit  prices  are  fair  the  valuation  is 
likely  to  be  fair.  If  the  unit  prices  employed  are  unstable 
the  A-aluation  will  be  unstable.  The  problem  of  unit  prices 
may,  therefore,  be  defined  as  the  problem  of  finding  above 
all  a  price  that  is  fair  to  both  producers  and  consumers  and 
that  will  maintain  its  standard  of  fairness  with  some  degree 
of  stability. 

This  discussion  of  unit  prices  is  premised  upon  a  theory  of 
valuation  which  may  be  summarized  briefly  somewhat  as 
follows:  The  principle  according  to  which  public  service 
properties  are  to  be  valued  is  the  competitive  principle. 
Though  they  exist  under  a  condition  of  monopoly  it  is  usually 
attempted  to  supply  the  conditions  existing  under  free  com- 
petition. Valuation  under  such  conditions  means  that  the 
prices  be  as  nearly  like  actual  market  valuations  as  possible. 
The  crucial  step  in  the  making  of 
market  valuations  is  taken  when 
the  buyer  and  seller  "clasp  hands 
and  a  bargain."  The  crucial  step 
in  the  making  of  valuations  for 
rate,  sale,  taxation,  or  other  pur- 
poses is  taken  when  the  appraising 
agency  exercises  an  honest  judg- 
ment. In  order  to  make  this  judi- 
cial act  as  nearly  as  possible  akin 
to  market  valuations  the  judicial 
agency   should  possess  the  same 

knowledge  of  facts  which  buyers  and  sellers  in  the  open  mar- 
ket are  presumed  to  possess.  This  means  that  inquiry  must 
be  made  of  the  original  cost  of  that  which  is  being  valued. 
The  definition  of  property  must  be  sufiiciently  flexible  to  in- 
clude both  the  tangible  and  intangible  elements.  This  infor- 
mation is  necessary  primarily  from  the  producers'  standpoint. 
Inquiry  should  also  be  made  of  the  cost  of  reproducing  the 
property  under  present  conditions.  This  information  is  im- 
portant from  the  consumers'  viewpoint.  Under  normal  con- 
ditions little  more  will  be  needed.  The  fair  value  will  emerge 
from  a  judicial  synthesis  of  these  two  estimates  of  cost,  of 
the  original  cost  as  an  index  of  past  investment  and  of 
replacement  cost  as  an  index  of  present  investment.  This 
method  of  valuation  gives  room  for  a  large  measure  of  pub- 
lic policy  and  avoids  the  dangers  of  arbitrary,  mathematical 
valuations. 

One  further  preliminary  observation  should  be  made. 
In  the  technical  process  of  valuation  the  problem  of  unit 
prices  arises  only  after  the  problem  of  inventory  has  been 
solved.  The  inventory  consists  of  the  items,  tangible  and 
intangible,  which  comprise  the  complex  of  property  being 
valued.  These  items  may  be  identical  with  the  unit  for 
which  prices  are  to  be  derived  or  they  may  represent  more 
than  such  unit.  If  they  represent  more,  the  unit  price  is 
usually  determined  for  an  engineering  quantity.  A  peculiar 
11 


PART  vn 
UNIT  PRICES 


THEIR  IMPORTANCE 

WHAT  THEY  INCLUDE 

HOW  THEY  SHALL  BE  DETERMINED 


case  arises  when  in  the  unit  price  there  is  included  an  over- 
head percentage  to  cover  incidental  costs.  So  far  as  possible 
these  costs  should  be  eliminated  from  unit  prices, — except 
when  they  enter  as  an  inherent  element  of  the  unit, — and 
made  a  separate  item  of  the  inventory  to  be  priced  separately. 
This  is  condusive  to  clearness  in  estimating  and  enables  a 
proper  comparison  of  the  two  types  of  cost  statistics. 

The  determination  of  unit  prices  therefore  consists  in 
finding  a  figure  which,  under  normal  conditions,  shall  fairly 
represent  first  the  actual  price  paid  in  the  past  or  the  probable 
price  which  would  have  to  be  paid  at  the  present  time  for 
the  items  enumerated  in  the  inventory.    It  is  not  possible 
in  this  paper  to  enter  into  the  minute  technical  details  which 
are  always  met  with.    The  problem  will  only  be  discussed 
in  its  larger  and  more  theoretical  aspects. 
What  is  a  fair  price?    Judicial  decision  has  given  the  rule 
that  it  is  the  price  paid  by  a  buyer, 
willing  but  not  obliged  to  buy,  to 
a  seller,  willing  but  not  obliged  to 
sell.   In  other  words,  it  is  the  com- 
petitive price   of  the  economist. 
Price  is  defined  as  exchange  value 
expressed  in  terms  of  money  where 
the  exchange  value  of  commodities 
is  a  concept  predicted  upon  their 
utiUty  and  scarcity.    Utihty  and 
scarcity,    operating    through    the 
forces  of  supply  and  demand,  de- 
termine the  price  of  commodities  in  the  market  place.    It 
will  not  be  necessary  to  present  a  further  analysis  of  the  forces 
lying  back  of  demand  and  supply.    It  is  sufficient  to  point 
to  the  generally  accepted  theory  expressed  by  John  Stuart 
Mill  that  "value  always  adjusts  itself  in  such  a  manner  that 
the  demand  is  equal  to  the  supply." 

The  point  of  adjustment  obviously  is  a  varying  one  de- 
pending upon  the  existing  state  of  demand  and  the  existing 
state  of  supply.  The  only  element  of  fixity  is  derived  from 
the  supply  side  where  ultimately  the  competition  between 
producers,  buyers  and  substitute  commodities  reacts  upon 
the  exchange  value  of  any  one  commodity  tending  to  fix  a 
price  which  is  equal  to  the  expenses  of  producing  it.  That 
price,  then,  which  represents  the  expense  of  producing  a  unit 
of  a  commodity  may  be  said  to  represent  its  normal  value, 
while  any  price  higher  than  this  represents  an  abnormal  value 
which  competitive  forces  are  continuously  seeking  to  reduce. 
This  reduction  is  accomplished  by  the  transferrence  of  the 
instruments  of  production,  nature,  labor,  enterpriser's 
services  and  capital  from  one  field  of  productive  enterprise  to 
another.  Inasmuch  as  a  period  of  time  is  required  to  effect 
this  transfer  it  may  be  concluded  that  the  strength  of  the 
tendency  of  actual  competitive  values  to  equal  normal  value 
is  dependent  upon  the  length  of  the  period  of  time  considered. 


162 


THE      UTILITIES      MAGAZINE 


It  is  in  the  light  of  normal  value  that  prices  ought  ordinarily 
to  be  fixed. 

It  should  be  noted  that  normal  value  does  not  represent  a 
cut-throat  or  bankruptcy  value.  It  represents  rather  that 
equilibrium  when  the  production  factors  are  satisfactorily 
rewarded.  This  should  clear  up  some  of  the  difficulties  with 
which  unit  prices  are  fraught.  The  price  applied  to  units  of 
quantity  should  include  beside  the  bare  cost  of  material  and 
labor  a  normal  allowance  for  interest  and  profit.  Such 
profits  are  necessary  and  sanctioned  by  competitive  practice. 

Normal  competitive  prices  are  also  best  ascertained  it  the 
commodities  valued  are  standard  commodities.  Non-stand- 
ard goods  represent  so  many  unique  qualities  that  the  indi- 
vidual estimates  of  buyers  and  sellers  vary  greatly.  Here 
price  fixation  is  necessarily  difficult.  In  the  case  of  standard 
commodities,  however,  which  are  widely  used  and  therefore 
have  a  wide  market,  competitive  forces  are  able  to  try  con- 
clusions. Patented  commodities  or  those  produced  under 
conditions  of  complete  or  partial  monopoly  are  other  excep- 
tions to  this  rule. 

Demand  and  supply  would  be  perfect  regulators  of  price 
for,  given  the  necessary  element  of  time,  normal  prices  would 
soon  be  reached.  But  competition  is  not  perfect.  Certain 
frictional  elements  are  always  present  and  those  too  cause 
fluctuations  in  price,  though  of  a  minor  character.  They 
can  be  merely  named  here.  Ignorance  of  one's  own  economic 
interest,  the  influence  of  custom,  the  inertia  of  investment, 
the  immobUity  of  labor,  unequal  taxation,  planless  produc- 
tion, and  even  the  presence  of  a  by-product  industry,  tend 
to  destroy  the  perfect  adjustment  designed  by  the  competi- 
tive principle. 

There  has  been  much  speculation  both  from  an  academic 
and  practical  viewpoint  as  to  the  cause  of  price  changes. 
Before  the  modern  era  the  price  of  all  staple  commodities  was 
fairly  constant.  The  reasons  for  this  were  to  be  found  in  the 
comparatively  simple  and  unchanging  methods  of  production, 
the  fact  that  market  demands  had  not  acquired  their  varie- 
gated forms  and  that  costs  of  production  were  constant  and 
could  be  relied  upon  with  greater  certainty.  Custom  played 
a  larger  part  than  at  the  present  time  in  fixing  prices,  and 
custom  is  a  conservative  force.  The  modern  era  was  ushered 
in  by  revolutionary  changes  in  the  methods  of  manufacture. 
Untried  processes  were  applied  which,  when  successful, 
caused  prices  to  change  rapidly.  Competitive  ingenuity  was 
better  able  to  try  conclusions.  Betterment  in  productive 
processes  brought  on  overproduction  which  had  a  depressing 
effect  upon  prices.  Certain  counteracting  tendencies  at 
once  set  in.  The  improvement  in  transportation  facihties 
made  possible  the  evening  up  of  price  levels  in  the  different 
producing  and  consuming  centers.  The  fact  that  many  of 
the  standard  commodities  have  become  trust  controlled  and 
subject  to  the  trust  policy  of  price  maintenance  has  been  a 
large  factor  in  keeping  prices  constant. 

There  may,  of  course,  be  a  general  rise  or  fall  of  prices. 
Such  a  phenomenon  would  imply  primarily  a  change  in  the 
value  of  money  or  better  the  value  of  the  standard  of  value. 
The  standard  of  value  has  been  defined  as  "any  commodity 
by  means  of  which  people  measure  and  express  the  value  of 


other  commodities."  A  standard,  in  modern  society,  also 
serves  the  purpose  of  comparing  and  recording  the  values  of 
the  various  articles  of  commerce.  The  value  of  the  standard 
is,  therefore,  inverse  to  the  level  of  prices.  Individual  com- 
modities may  change  quickly  in  price  because  their  exchange 
ratio  has  changed  relatively  to  one  another.  In  order  that 
the  price  of  all  commodities  change  in  the  same  direction  it 
is  necessary,  however,  that  there  be  a  change  in  the  standard 
which  would  necessarily  require  a  long  period  of  time. 

Economists  distinguish  the  following  causes  affecting  a 
change  in  prices: 

1.  Prices  may  rise  due  to  a  rise  in  the  exchange  ratio  of 
commodities. 

2.  Prices  may  rise  due  to  a  fall  in  the  value  of  the  standard 
commodity. 

3.  Prices  may  fall  due  to  a  fall  in  the  exchange  ratio  of 
commodities. 

4.  Prices  may  fall  due  to  a  rise  in  the  value  of  the  standard 
commodity. 

In  countries  with  a  secondary  standard  of  value  prices  may 
also  rise  as  the  secondary  standard  depreciates  with  respect 
to  the  primary  and  fall  as  it  appreciates. 

This  brief  analysis  may  have  been  sufiicient  to  show  that 
the  act  of  valuation  as  based  upon  the  competitive  operations 
of  demand  and  supply  is  a  difficult  one  to  perform  with  any 
degree  of  accuracy.  The  degree  of  accuracy  of  the  valuation 
will  depend  primarily  upon  the  accuracy  with  which  the 
prices  that  are  used  reflect  the  normal  operations  of  the 
market.  To  be  exactly  accurate  valuations  should  change 
with  every  change  in  the  prices  of  which  they  are  composed. 
But  a  glance  at  competitive  industry  will  disclose,  however, 
that  nowhere  is  any  attempt  being  made  to  derive  either 
exact  or  fixed  valuations.  Compromises  are  being  effected 
continually  through  reorganizations  and  receiverships. 

Without  a  special  investigation,  always  difficult  and  never 
accurate,  it  will  be  impossible  to  determine  whether  changes 
in  prices  are  due  to  causes  operating  upon  commodities  or 
due  to  causes  operating  upon  gold.  These  two  sets  of  causes 
should  be  separated  out  and  studied  with  respect  to  each 
item.  Such  an  examination  will  usually  disclose  that  prices 
move  according  to  two  separate  plans  representing  distinct 
forces  acting  simultaneously.  There  will  be  price  movements 
covering  short  periods  of  time  and  movements  of  longer 
duration.  A  priori  one  would  say  that  the  short  period 
movements  are  caused  by  temporary  changes  affecting  de- 
mand and  supply,  while  the  long  period  movements  are 
caused  by  more  permanent  changes.  The  former  are  usually 
held  to  be  changes  affecting  commodities  in  general,  the 
latter  changes  affecting  the  commodity  used  as  the  standard 
of  value. 

Valuations  for  purposes  of  rate  making  aim  primarily  to 
get  an  equitable  and  economically  sound  basis  for  determin- 
ing fixed  charges  for  a  future  period  of  time.  Evidence  of 
past  cost  is  necessary  in  order  to  permit  consideration  of 
equity.  Evidence  of  present  cost  is  necessary  in  order  to 
properly  gauge  the  effect  of  economic  changes  on  future 
production. 

In  determining  the  unit  prices  which  shall  be  applied  to 


UNIT      PRICES 


163 


inventories  so  that  the  result  will  show  the  actual  expendi- 
tures incurred  reference  must  be  had  to  the  prices  actually 
prevailing  at  the  time  the  properties  were  constructed. 
These  unit  prices  can  be  determined  from  accounts  and 
other  supporting  evidence.  In  case  the  actual  cost  cannot 
be  ascertained  from  the  records  an  estimate  should  be  made 
which  will  apply  the  average  price  paid  for  materials  and 
labor  during  the  period  of  construction.  In  determining  the 
cost  of  reproduction  a  correct  application  of  the  theory 
would  require  that  the  prices  be  the  prevailing  price  for  a 
period  equivalent  to  a  construction  period.  Since  the  date 
of  valuation  may  fall  within  a  period  of  abnormally  low  or 
high  prices,  it  has  been  the  practice  of  some  regulating 
bodies  to  apply  ideal  prices  which  represent  neither  the 
actual  price  nor  the  present  prevailing  price  but  rather  the 
trend  of  prices.  In  ascertaining  prices  based  upon  the  gen- 
eral trend  the  average  price  for  a  period  of  years,  usually 
from  5  to  10  years,  has  been  ascertained  and  applied.  This 
practice  is  defended  on  the  ground  that  such  ideal  prices  will 
more  nearly  reflect  the  future  cost  of  these  properties  and 
will  therefore  best  insure  permanency  of  the  rate  schedules. 

It  has  been  generally  held  by  courts  and  commissions  that 
unit  prices  may  contain  besides  the  bare  cost  of  labor  and 
materials  an  allowance  for  contractor's  profit.  In  addition 
unit  prices  should  cover  all  the  costs  of  transportation, 
handling  and  storage.  There  has  been  some  disagreement, 
however,  when  allowance  is  to  be  made  for  transportation 
costs  over  the  carrier's  own  lines. 

Before  the  advent  of  regulation,  it  had  been  the  practice 
to  charge  into  the  construction  accounts,  amounts  estimated 
to  be  equal  to  the  cost  of  movement  of  men  and  materials. 
This  amount  was  not  designed  to  cover  any  allowance  for 
profit.  The  contention  of  carriers  now  is  that  this  allowance 
is  insufficient  in  view  of  the  interpretation  that  cost  to  an 
operating  utility  for  materials  going  into  permanent  plant 
means  operating  expenses  plus  profit. 

In  the  competitive  field  materials  required  in  the  construc- 
tion of  permanent  plant  pay  the  regular  tariff  rates.  This 
is  true  also  of  the  materials  going  into  the  construction  of 
other  utility  properties  besides  railroads.  Should  an  excep- 
tion be  made  when  the  utility  is  its  own  forwarding  agent? 

The  construction  organization  of  railway  companies  has 
always  been  regarded  as  distinct  from  the  operating  organi- 
zation. It  is  true  that  this  distinction  has  been  principally 
one  of  convenience.  Only  in  this  way,  however,  could  con- 
struction expenses  be  properly  segregated  and  finally  charged 
to  capital  where  they  belonged.  When  the  work  has  been 
done  by  contractors,  the  original  contract  usually  stipulated 
what  charges,  if  any,  shall  be  made  for  the  transportation  of 
men  and  materials.  If  the  contract  required  the  payment  of 
regular  tariff  rates,  it  is  certain  that  this  item  was  taken  into 
consideration  by  the  contractor.  The  question  whether  a 
railroad  can  properly  charge  itself  rates  for  construction 
materials  which  pay  a  profit  can  best  be  decided  without 
reference  to  past  practices.  In  view  of  the  competitive 
organization  of  all  industry  there  should  be  no  question  that 
a  railway  under  construction  pay  full  tariff  rates  on  materials 
transported  over  foreign  lines.    The  full  amount  of  such 


charges  represents  construction  costs  properly  chargeable  to 
capital.  When  such  materials  are  hauled  over  the  line  of  a 
carrier  which  is  still  under  construction  and  not  yet  handed 
over  to  the  operating  organization,  it  is  immaterial  whether 
such  haulage  is  undertaken  free  of  charge  or  at  revenue  rates, 
because  in  the  first  case  the  costs  would  be  regarded  as  an 
operating  expense  during  construction  and  charged  to  capi- 
tal, while  in  the  latter  case  the  revenues  would  be  regarded 
as  earning?  during  construction  and  credited  to  capital. 
This  procedure  is  proper  because  there  is  underlying  the 
whole  construction  process  the  idea  of  permitting  as  a  rea- 
sonable capital  cost  interest  during  construction. 

Thus  expenditures  for  materials  and  labor  going  directly 
or  indirectly  into  construction  are  not  left  uncompensated. 
As  soon  as  a  requisite  portion  of  the  line  has  been  completed, 
it  is  turned  over  to  the  operating  organization.  Interest 
during  construction  ceases  and  the  capital  sunk  in  construc- 
tion must  seek  its  remuneration  through  operations  for 
profit.  Regular  tariff  rates  are  published  and  applied  with- 
out discrimination  to  all  traffic  carried.  If  the  road  carried 
materials  required  in  operation,  it  is  again  immaterial  whether 
it  carried  them  free  or  at  revenue  rates.  The  expenses  and 
earnings  would  alike  enter  into  its  yearly  income  account. 
Since  such  materials  are  transported  for  the  sake  of  operation 
they  represent  a  cost  of  operation.  When  a  carrier  trans- 
ports materials  not  for  purposes  of  operation,  but  for  pur- 
poses of  construction,  the  cost  of  performing  such  service 
cannot  be  charged  to  operation,  but  should  be  charged  to 
capital.  If  this  cost  is  interpreted  to  mean  merely  operating 
expenses,  there  has  been  no  return  upon  the  fixed  capital 
employed  in  operation  and  its  services  are  to  that  extent 
uncompensated.  If  the  materials  are  carried  at  a  profit, 
such  profit  goes  to  compensate  capital  invested  in  operation 
and  not  capital  invested  in  construction.  If  the  profits  thus 
earned  from  carrying  construction  materials  make  the 
aggregate  profit  earned  on  capital  invested  in  operation 
excessive,  such  profit  is  subject  to  the  statutory  right  of 
limitation.  The  above  it  would  seem  should  at  least  be 
the  view  held  with  respect  to  such  operations  in  the  future. 

The  reasons  advanced  for  the  use  of  normal  unit  prices 
should  not  be  interpreted  as  an  argument  in  behalf  of  a  mere 
averaging  of  prices  for  some  time  past.  This  mistaken  con- 
ception of  the  nature  of  normal  unit  prices  has  brought  on 
considerable  opposition  in  some  quarters.  Mr.  H.  L.  Gray, 
chief  engineer  of  the  Washington  Commission,  for  instance, 
disapproves  of  the  use  of  average  prices.  "In  preparing 
such  appraisals,"  he  says, 

"it  has  frequently  been  the  custom  to  use  the  average  of 
prices  prevailing  during  several  years  previous,  this  method 
being  based  upon  the  assumption  that  the  number  of  years 
selected  would  cover  the  construction  period.  The  wisdom 
of  so  selecting  prices  has  not  been  clearly  demonstrated. 
If  the  plant  is  new,  and  actually  was  constructed  during  the 
years  selected,  then  the  advantage  is  obvious,  but  if  the 
date  of  appraisal  is  remote  from  the  date  of  construction, 
why  average  a  number  of  prices  that  bear  no  relation  to  the 
actual  cost,  or  the  prevailing  prices?  It  is  equally  fair  and 
much  more  convenient  to  assume  that  the  date  of  the  ap- 
praisal represents  the  beginning  of  the  construction  period, 
rather  than  the  end.     It  may  be  well  said  that  the  past 


164 


THE      UTILITIES      MAGAZINE 


years  exhibit  the  prevailing  cost  of  work,  while  those  of  the 
future  do  not.  Nevertheless,  it  should  be  borne  in  mind 
that  practically  all  the  material  will  be  contracted  for  at  the 
beginning  of  the  work,  and  that  labor  costs  are  apt  to  vary 
materially  in  three  or  four  years.  After  all,  the  probable 
construction  period  is  an  assumption,  either  way  it  is  taken, 
and  the  folly  of  sphtting  hairs  over  assumptions,  and  en- 
tailing a  great  deal  of  additional  work,  should  be  evident, 
particularly  when  it  is  remembered  that  the  cost  of  repro- 
duction is  only  one  element  of  the  value." 

It  is  obvious,  of  course,  that  a  criticism  directed  against 
the  mere  averaging  of  prices  is  not  valid  when  such  averaging 
is  for  the  purpose  of  determining  a  normal  price.  It  is  not 
unusual  that  a  current  market  price  can  be  taken  as  the 
normal  price  if  upon  investigation  this  is  found  to  be  the  case. 
In  the  case  of  some  materials,  such  as  lumber  and  ties,  the 
price  of  which  has  been  steadily  rising,  current  quotations 
may  be  much  nearer  the  normal  price  and  an  average  price 
determined  for  some  years  back  essentially  unfair.  The 
practice  of  averaguig  prices  represents  no  hard  and  fast  rule 
and  is  merely  a  useful  device  for  determining  normal  price 
in  the  case  of  materials  showing  wide  fluctuations. 

The  price  of  cast  iron  pipe  affords  a  good  illustration  of  the 
problem  of  unit  prices.  The  violent  and  erratic  fluctuations 
of  price,  recurring  at  varying  intervals,  and  most  noticeable 
in  the  current  price  of  base  materials,  may  be  eliminated  by 
taking  only  the  average  price  for  the  year. 

The  movement  of  the  price  of  cast  iron  water  pipe  was 
traced  from  1883  to  1912.  The  lowest  average  yearly  price 
of  $16  was  attained  during  1898  while  the  highest  price  of 
$36.50  was  reached  in  1907.  The  range  represented  by  these 
price  levels  is  approximately  $20.  The  average  price  as 
well  as  the  median  price  for  the  26-year  period  is  $26  per 
ton.  No  distinct  modal  price  seems  to  have  prevailed;  $27 
per  ton  and  $31  per  ton  appear  to  have  been  the  prices  most 
frequently  quoted.  The  five-year  average  begins  with  a 
price  of  about  $28  per  ton  in  1888  with  a  general  downward 
trend  until  in  1898  a  price  of  $18  per  ton  is  reached.  From 
this  time  forward  the  general  trend  is  upward,  culminating 
in  a  price  of  $30  per  ton  in  1910.  Since  then  the  general 
price  tendency  has  been  downward.  The  ten-year  average 
of  prices  follows  the  five-year  average  in  its  general  trend. 

These  statistical  facts  are  of  large  importance  in  their 
practical  apphcation  to  problems  of  price  fixing.  For  in- 
stance, it  may  be  assumed  that  a  water  works'  plant  has 
installed  certain  quantities  of  cast  iron  pipe  in  its  distribu- 
tion system,  and  that  the  actual  installation  covered  a  period 
of  one  year.  In  estimating  the  cost  of  reproduction,  some 
decision  for  one  or  the  other  of  these  price  levels  must  neces- 
sarily be  made.  The  importance  of  making  a  proper  choice 
can  best  be  seen  by  actual  illustration. 

In  a  recent  water  works  case  before  the  Wisconsin  Railroad 
Commission  the  valuation  of  the  plant  had  to  be  determined 
for  the  purposes  of  rate  fixing.  The  cost  of  reproduction 
new  of  the  plant,  excluding  the  item  of  cast  iron  pipe,  was 
fixed  at  $503,068.  A  wide  range  of  prices  was  available. 
If  it  is  logical  to  judge  future  prices  by  those  of  the  past, 
there  was  evidence  to  show  that  the  price  might  vary  any- 


where between  $16  and  $36  per  ton.  During  the  period  of 
29  years,  $27  per  ton  was  a  price  more  often  quoted  than  any 
other.  In  view  of  the  fact,  however,  that  the  price  fixing  is  to 
be  applied  a  priori  to  a  period  immediately  succeeding  the 
present,  the  level  of  prices  during  the  present  year  or  a  few 
immediately  preceding  would  be  more  important  as  an  index 
of  future  prices.  For  this  purpose  five-  and  ten-year  aver- 
ages are  important.  They  tend  to  introduce  the  principle 
of  least  error.  Except  in  the  two  extreme  cases  of  the  year 
1898  when  the  price  rose  $9  per  ton  and  the  year  1907  when 
it  fell  by  about  the  same  amount,  these  two  types  of  moving 
average  prices  represent  the  general  trend  of  prices.  Con- 
sidering the  longevity  of  cast  iron  pipe  and  its  fairly  standard 
nature,  the  ten-year  average  would  seem  to  best  meet  the 
conditions  of  the  problem. 

The  following  table  wi!l  serve  to  show  the  variation  in 
estimates  resulting  from  an  application  of  the  different  pos- 
sible price  levels: 


Esti- 
mated 
Cost 

USING 
MiN. 

Pkice  of 
$16 

FEB  Ton 

Esti- 
mated 
Cost 

USINO 

Max. 
Pbice  of 

$36 
PEB  Ton 

Esti- 
mated 
Cost 

DBINQ 

Modal 
Pbice  of 

$27 
PEB  Ton 

Esti- 
mated 
Cost 

USING 

e-ra. 
Ave.  of 

$25 
PEB  Ton 

Esti- 
mated 
Cost 
trsiNG 

10-YB. 

Ave.  op 

$28 
PEB  Ton 

Cost  New  of  Plant  exc. 
C.  I.  Pipe 

$503,068 
71,335 

$503,068 
160,540 

$503,068 
120,410 

$503,068 
111,493 

$503,068 

Cost  New  Cast  Iron  Pipe. 

124,869 

Total  Cost  New 

Per  Cent  of  Minimum  Cost 

574,403 
100.00 

663,608 
115.53 

623,478 
108.54 

614,561 
106.99 

627,937 
109.32 

Another  type  of  price  movements  is  illustrated  by  the 
wages  of  general  railway  labor.  While  here,  too,  average 
prices  show  considerable  yearly  variation,  their  general  trend 
has  been  upward.  Under  such  conditions  estimates  of  the 
cost  of  reproduction  are  unfair  when  based  upon  any  aver- 
aging of  past  prices.  On  the  contrary,  it  would  seem  that  a 
fairer  result  is  obtained  by  taking  either  present  yearly 
average  price  or,  better  still,  the  price  indicated  as  the  present 
general  trend. 

There  is  no  known  method  by  means  of  which  future  prices 
can  be  accurately  prognosticated.  Nor  is  this  at  all  neces- 
sary in  valuations  for  rate  making  purposes.  The  price 
bargain  between  producers  and  consumers  of  pubHc  utility's 
services  cannot  from  the  very  nature  of  these  enterprises, 
with  their  large  investments  in  fixed  capital,  be  based  upon 
a  theory  of  constantly  impending  competition.  It  is  suflB- 
cient  if  the  valuations  in  broad  outline  take  cognizance  of 
the  increases  or  decreases  in  the  costs  of  supplying  the  fixed 
capital,  just  as  a  rate  cannot  be  made  to  change  automatically 
with  increases  and  decreases  in  the  circulating  capital  costs 
or  other  operating  expenses. 

Since  the  work  and  expense  of  conducting  valuations  are 
extraordinarily  heavy,  economy  alone  would  dictate  that 
valuations  should  be  put  upon  such  a  price  basis  as  will  tend 
to  preserve  the  validity  of  the  valuations  for  some  time  to 
come.    If  valuation  is  to  become  the  cornerstone  of  rate 


FINANCIAL    ASPECTS    OF    VALUATION 


165 


regulation,  it  would  seem  to  be  necessary  not  only  that  the 
original  valuations  be  as  stable  as  possible,  but  also  that 
steps  be  taken  to  keep  these  valuations  abreast  of  the  times 
so  far  as  prices  are  concerned.  A  permanent  organization 
such  as  the  present  division  of  valuations  should  be  formed 


to  study  and  report  the  movement  of  prices,  to  correct  the 
inventories  and  apply  the  new  unit  prices,  and  in  general 
to  present  all  those  studies  and  perform  all  those  oper- 
ations which  shall  reasonably  preserve  the  integrity  of  the 
valuations. 


FINANCIAL  ASPECTS  OF  VALUATION 

By  Paul  A.  Sinsheimer 

Bond  Expert  of  the  California  Railroad  Commission 


WE  HAVE  chosen  upon  valuation  as  a  pivotal 
element  in  the  regulation  of  our  public 
utilities.  If  our  gathering  here  denotes  our 
belief  that  it  is  a  topic  capable  of  cold,  exact,  legal  anal- 
ysis and  determination,  I  fear  that  our  earnest  efforts 
are  conceived  in  failure.  If,  on  the  other  hand,  we 
recognize  the  subject  as  living,  and  warm  with  purpose, 
we  may  hold  out  high  hope  of  accomplishment. 

A  discussion  of  valuation  may  defeat  itself  by  merely 

dedicating  itself  to  the  stand-     

ardization  and  legalization  of 
that  which  has  already  grown 
into  being. 

Valuation  must  throb  with 
the  human  element.  It  must, 
above  all,  represent  an  en- 
deavor, and  an  honest  en- 
deavor, to  do  justice  and  equity 
among  men. 


FINANCIAL  SECRETARY 
NEEDED 


PART  vm 

FINANCIAL  ASPECTS  OF  VALU 
ATION  AND  REGULATION 


"The  ascertainment  of  that 
value,"  said  Mr.  Justice  Hughes 
in  the  Minnesota  Rate  Case,  "is 
not  controlled  by  artificial  rules. 

It  is  not  a  matter  of  formulas,  but  there  must  be  a  rea- 
sonable judgment  having  its  basis  in  a  proper  consider- 
ation of  all  relative  facts." 

It  may  reasonably  be  asked  what  all  this  has  to  do 
with  the  financial  aspects  of  valuation.  And  the  answer 
is  that  it  is  a  basis  upon  which  the  financial  considera- 
tions which  enter  into  valuation  must  rest. 

We  have  progressed  to  a  stage  where  we  set  forth 
concisely  our  premises  for  the  valuations  of  today  and 
yesterday  with  small  thought  of  the  valuations  of 
tomorrow.  We  establish  our  standards  to  ascertain 
reproduction  cost,  original  cost  or  market  value  and  in 
so  doing  we  close  our  eyes  to  the  obvious  deficiencies 
of  our  methods.  We  would  do  well  to  analyze  more 
closely  the  facts  upon  which  our  standards  are  depend- 
ent. I  know  of  no  more  profitable  avenue  of  inquiry 
than  that  of  financial  understanding. 


INFLATED  COSTS  OF  MONEY  AND  MATER- 
IALS 

NEED  FOR  CLOSER  CONTROL  OF  CREDIT 

NECESSITY  FOR  REGULATING  PRICES  OF 
PUBLIC  UTILITY  MATERIALS  UNDER 
MONOPLY  OWNERSHIP 

PROPER  ACCOUNTING 

PUBLICITY  IN  ACCOUNTS 

CONFIDENCE  IN  INVESTMENT  CIRCLES 


The  properties  that  enter  into  a  public  utility  cor- 
poration must  be  acquired  through  its  stock,  its  bonds, 
its  notes  and  accounts,  its  surplus  earnings  and  occa- 
sionally through  bonuses  and  donations.  A  scrutiny 
of  the  financial  affairs  of  a  corporation  must  reveal  the 
outgo  for  each  acquisition. 

EXAMPLE  OF  CALIFORNIA 

I  can  best  illustrate  by  reference  to  the  practice  of 
the  Railroad  Commission  of 
California.  It  has  been  the 
policy  of  that  Commission  to 
handle  all  matters  pertaining 
to  the  finances  of  public  utility 
corporations  through  what  is 
called  its  Stock  and  Bond  De- 
partment. This  department 
has  passed  upon  the  issue  of 
$550,000,000  of  public  utility 
corporation  stock  and  bonds, 
has  subjected  them  to  careful 
analysis,  and  in  pursuance  of 
this  work  has  examined  some- 
what carefully  into  the  finances 
generally  of  these  corporations. 
This  has  entailed  a  study  of 
the  corporation  from  its  origin,  tracing  each  issue  of 
stock  and  bonds,  the  money  received  therefor  and 
the  application  of  the  funds.  A  special  endeavor  has 
been  made  to  determine  the  value  of  the  assets  acquired 
and  their  relation  to  their  cost.  A  similar  investiga- 
tion has  been  undertaken  by  this  department  of  the 
California  Railroad  Commission  among  railroad  and 
public  utility  corporations,  national  in  their  extent  and 
importance. 

ORIGINAL  COST  DECEPTIVE 

The  results  proclaim  the  necessity  for  the  exercise 
of  a  discriminating  caution  in  accepting  cost  as  value; 
or,  to  phrase  it  somewhat  differently,  in  accepting 
cost  as  the  basis  upon  which  the  regulating  body  should 
predicate  public  utility  earnings. 

The  reasons  for  this  are  twofold;    first,  manipula- 


166 


THE      UTILITIES      MAGAZINE 


tion,  and  second,  inflated  costs  of  money  and  materials. 
By  manipulation  I  mean  the  illicit  profit  and  the 
breach  of  trust.  The  inflated  costs  of  money  and 
material  arise  from  centralized  credit  and  the  control 
of  materials-  by  unrestrained  monopoly.  The  first  may 
not  be  difficult  to  remedy.  The  second  will  present  a 
formidable  issue. 

I  am  persuaded  that  a  large  part  of  the  ills  to  which 
public  utility  corporations  are  subject  is  attributable 
to  the  illicit  profit.  Great  fortunes  are  rarely  made 
from  the  earnings  that  accrue  from  railroad  stocks  and 
bonds.  They  have  come  rather  from  the  excessive 
profits,  either  through  the  financial  manipulation  of 
railroad  affairs  or  through  excessive  profit  in  the  sale 
of  railway  materials.  And  these  excessive  and  often 
illegitimate  profits  are  added  to  cost  and  we  invariably 
include  them  when  we  adhere  rigidly  to  valuation  by 
original  cost. 

MILLIONS  MAY  BE  WASTED 

The  investigation  by  the  Interstate  Commerce  Com- 
mission into  the  affairs  of  the  New  York,  New  Haven 
and  Hartford  Railroad  revealed  shocking  divergence 
between  original  cost  and  value;  the  expenditure  of 
$36,000,000  to  acquire  the  Westchester  line  of  an 
estimated  value  of  $6,000,000;  the  expenditure  of 
$24,000,000  in  money  and  securities  for  the  trolley  lines 
of  Providence,  representing  a  cash  investment  of  less 
than  $10,000,000  for  an  outlay  of  $25,000,000.  "  From 
all  of  the  foregoing,  and  from  a  consideration  of  the 
method  in  which  expenditures,  not  specified  here,  have 
been  made," said  the  Interstate  Commerce  Commission, 
"it  is  submitted  that  a  reasonable  estimate  of  the  loss 
to  the  New  York,  New  Haven  and  Hartford  Railroad 
Company,  by  reason  of  waste  and  mismanagement 
will  amount  to  between  $60,000,000  and  $90,000,000." 

The  record  of  exploitation  and  iniquity  might  be 
extended.  But  the  case  does  not  require  such  corrobo- 
ration. 

The  effect  upon  value  of  the  high  cost  of  money  and 
materials  has  been  given  less  attention  and  I  prefer, 
therefore,  to  deal  more  at  length  with  that  aspect  of 
public  utility  business. 

EXCESSIVE  BANKING  PROFITS 

Not  long  ago  a  western  company,  finding  itself  in 
pressing  need  of  funds,  called  in  the  services  of  one  of 
the  largest  New  York  financial  houses.  The  data  as 
finally  arranged  were  presented  to  the  California 
Commission  and  they  included  cost  multiplied  upon 
cost  for  engineering  services,  extra  audits,  legal  ex- 
penses, banking  commissions,  all  of  which,  as  a  matter 
of  fact,  made  the  actual  cost  to  the  corporation  twice 
the  normal.    The  officials  of  the  utility  had  come 


previously  to  the  Commission,  and  announced  their 
disinclination  to  submit  to  the  terms  proposed,  but 
had  admitted  their  inability  to  protest.  When  the 
matter  was  finally  submitted  to  the  California  Com- 
mission the  point  was  raised  that  the  demands  were 
excessive  and  unreasonable. 

"I  will  admit,"  said  the  attorney  for  the  New  York 
financial  house,  "that  my  clients  are  robbing  these 
gentlemen,  but  I  would  add  that  these  gentlemen 
should  be  proud  to  be  robbed  by  my  chents;  for  cor- 
porations all  over  the  country  have  at  this  season 
begged  my  clients  to  rob  them,  but  they  have  con- 
sented to  rob  only  the  most  worthy." 

The  effect,  of  course,  was  to  give  a  wholly  exag- 
gerated statement  of  original  cost.  A  monstrous 
banking  profit  had  been  exacted. 

RAILROADS  LIKE  TAMMANY 

When  we  enter  the  domain  of  prices  and  cost  of  mate- 
rials we  again  encounter  a  highly  organized  conditon. 
Engineering  firms,  in  close  alliance  with  the  large 
supply  houses,  have  grown  into  being,  which  impose 
a  charge  ranging  from  5  per  cent  to  7^  per  cent  and 
10  per  cent  of  the  cost  of  the  actual  construction  work. 
This  item  passes  regularly  into  the  original  cost. 

The  city  of  Boston  found  its  freedom  of  purchase 
denied  in  the  steel  industry  under  the  so-called  New 
England  agreement.  Mayor  Baker  of  Cleveland  felt 
obliged  to  resort  to  the  threat  of  an  appeal  to  Congress 
to  bring  bids  for  the  equipment  for  the  new  Cleveland 
municipal  electric  plant. 

Mr.  Charles  S.  Mellen  apparently  was  intimately 
conscious  of  the  abuse  arising  from  the  cost  of  money 
and  the  cost  of  materials  to  the  railroads. 

"A  great  railroad,"  said  Mr.  Mellen,  "is  more  nearly  like 
a  Tammany  political  organization  than  the  people  have 
ever  imagined,  and  the  attitude  toward  the  stockholders 
by  bosses  of  the  railroad  is  not  different  from  the  attitude 
toward  the  people  by  political  bosses.  Too  often  the  boards 
of  directors  of  our  corporations,  in  handling  the  business  of 
stockholders,  are  like  some  boards  of  aldermen  or  the  mem- 
bers of  the  legislatures  in  our  cities  and  states.  They  do 
not  represent  the  stockholders  at  all.  They  really  represent 
and  are  under  the  control  of  bosses  entirely  outside,  who 
make  enormous  profits  through  their  control  of  the  railroad 
in  outside  business." 

PROFIT  IS  IN  COST 

I  shall  quote  again  from  Mr.  Mellen: 

"I  would  also  compel  the  railroad  managers,"  said  he, 
"to  advertise  for  bids  for  all  purchases  of  any  considerable 
amount  and  for  all  construction  work  and  other  work  which 
involves  a  large  expenditure." 

And  again: 


FINANCIAL    ASPECTS    OF    VALUATION 


167 


"The  cry  against  public  ownership  will  vanish  in  the  air 
when  once  the  opportunity  for  making  profit  out  of  the 
'concessions,'  so  to  speak,  of  the  business  is  gone." 

These  two  elements,  the  cost  of  money  and  the  cost 
of  materials,  obviously  affect  most  intimately  the 
original  cost  of  any  public  utility  enterprise.  And 
heretofore,  in  all  of  our  discussions  of  the  subject  of 
value,  we  have  been  prone  to  accept  original  cost  as 
representing  the  actual  outlay  required  by  the  enter- 
prise. Now  we  are  very  apt  to  find,  if  we  establish 
ourselves  upon  the  basis  of  original  cost,  that  we  are 
in  reality  merely  bolting  the  front  door  and  leaving 
the  back  door  wide  open. 

In  any  consideration  of  the  financial  affairs  of  a 
utility  corporation  it  is  just  as  essential  that  it  buy 
cheaply  as  that  it  sell  high.  The  profit  does  not  lie 
in  the  sale  price.  It  lies  in  the  difference  between  the 
sale  price  and  the  cost.  Whenever,  therefore,  we  ac- 
cept an  inflated  cost  of  money  or  an  inflated  cost  of 
materials,  we  thereby  recognize  an  inflated  capital 
account  and  an  inflated  amount  to  be  produced  through 
the  rates. 

NEED  CHEAP  MONEY 

Before  we  may  obtain,  therefore,  a  clear  and  ade- 
quate view,  perhaps  not  of  original  cost,  but  in  reality 
of  "reasonable  cost,"  public  authority  should  address 
itself  to  the  financial  aspects  of  a  corporation  to  deter- 
mine: first,  that  it  is  so  financed  through  its  stock  and 
bond  issues  as  to  enable  it  to  command  the  highest 
credit;  and  second,  that  it  pays  no  more  than  is  re- 
quired for  the  money  it  must  obtain. 

But  this  again  is  not  all.  The  banks  of  the  country, 
greater  public  utilities  in  a  real  sense,  obtain  their 
funds  at  a  cost,  exclusive  of  overhead  expense,  of  less 
than  4  per  cent.  It  is  to  the  interest  of  the  country 
that  they  should  obtain  money  cheaply  and  be  able  to 
lend  it  out  cheaply.  It  is  equally  of  interest  to  the 
people  of  the  country  that  the  utility  should  be  enabled 
to  borrow  money  cheaply  and  to  thrive  on  a  low 
return  of  earning. 

STATE  LIMIT  ON  INTEREST 

Government  has  begun  to  take  an  interest  in  this 
aspect  of  its  economic  life.  We  have  had  monetary 
readjustment  calculated  to  decentralize  credit  and 
make  it  more  available  for  legitimate  industry.  Is  it 
not  a  part  of  the  function  of  government  to  go  further 
forward,  to  the  end  that  the  public  utility,  dedicated 
to  the  public  service,  shall  be  enabled  to  borrow  on 
the  lowest  possible  basis?  Would  it  not  be  the  part 
of  wisdom  for  government  not  only  to  regulate  the 
issues  of  stocks  and  bonds  by  its  public  utility  corpora- 
tions, not  only  to  exercise  a  financial  supervision  which 


shall  eliminate  the  illicit  profit  and  the  breach  of  trust, 
but  to  extend  increasing  opportunities  of  credit.'' 

When  we  see  utility  corporations  struggling  in  the 
market  for  money  at  10  per  cent,  11  per  cent  and  even 
higher  rates  of  interest,  we  know  that  something  is 
wrong,  for  these  interest  rates,  of  course,  either  go 
into  the  capital  accounts  and  valuations  of  these  util- 
ities, or  they  so  sorely  impair  its  credit  that  all  of  its 
costs  must  rise. 

Government  could  well  undertake  a  closer  control 
of  credit.  It  has  chosen  to  surrender  the  power  to  the 
caprice  of  private  profit.  The  investment  funds  of 
the  country  constitute  the  driving  force  of  its  indus- 
trial life.  Government  should  require  that  they  be 
not  dissipated,  but  be  made  available  for  legitimate 
industry  on  reasonable  terms. 

I  speak  not  in  criticism,  but  by  way  of  earnest  sug- 
gestion. 

ROOT  FOR  REGULATION 

A  few  years  ago  a  suggestion  looking  to  the  regula- 
tion by  government  of  the  essential  materials  under 
monopoly  control,  which  enter  into  public  utility 
enterprises,  might  have  been  regarded  as  somewhat 
drastic.  But  we  are  now  in  an  advancing  day  and 
many  things  are  coming  to  pass  which  yesterday 
seemed  in  the  far-away. 

Elihu  Root,  United  States  Senator  from  New  York, 
and  formerly  Secretary  of  State,  in  a  recent  pronounce- 
ment has  recognized  the  trend  of  affairs.  "To  attain 
the  ends  which  every  one  agrees  ought  to  be  attained," 
said  he,  "it  appears  necessary  that  government  shall 
interfere  to  a  much  greater  extent  than  in  former  times 
with  the  complicated  and  interdependent  life  of  the 
people. " 

Of  particular  interest  is  the  recent  declaration  of 
the  United  States  Supreme  Court.  "The  basis  of  the 
ready  concession  of  the  power  of  regulation  is  the 
public  interest,"  declared  Mr.  Justice  McKenna  in 
the  German  Alliance  Insurance  case.  "Against  that 
conservatism  of  the  mind  which  puts  to  question  every 
new  act  of  regulating  legislation,"  said  he,  "and  re- 
gards the  legislation  invalid  or  dangerous  until  it  has 
become  familiar,  government — ^state  and  national — 
has  pressed  on  in  the  general  welfare;  and  our  re- 
ports are  full  of  cases  where  in  instance  after  instance 
the  exercise  of  regulation  was  resisted  and  yet  sus- 
tained against  attacks  asserted  to  be  justified  by  the 
Constitution  of  the  United  States.  The  dread  of  the 
moment  having  passed,  no  one  is  now  heard  to  say 
that  rights  were  restrained  or  that  constitutional 
guarantees  impaired." 


168 


THE      UTILITIES      MAGAZINE 


COAL,  LUMBER  AND  OIL 

We  learn  that  the  bituminous  coal  interests  have  at 
different  times  themselves  voluntarily  urged  upon  the 
national  government  the  wisdom  of  combination  under 
Federal  control  with  government  regulation  of  prices. 

Before  the  Federal  Trade  Commission,  during  its 
hearing  on  the  lumber  industry  in  August  of  this  year, 
Mr.  G.  X.  Wendling,  representing  extensive  lumber 
interests  on  the  Pacific  Coast,  urged  the  same  regula- 
tion of  that  industry  by  the  government,  with  the  right 
lodged  in  public  authority  to  fix  and  determine  the 
prices  at  which  lumber  should  sell.  His  plea  was  for 
"legalized  co-operation"  under  rigid  government  regu- 
lation. 

In  the  state  of  California,  operators  in  the  oil  indus- 
try have  urged  that  petroleum  be  declared  a  public 
utility  with  the  right  lodged  with  public  authority 
to  determine  the  price  of  sale.  The  same  suggestion 
was  advanced  by  a  member  of  President  Taft's  cabinet. 
During  the  present  year,  men  in  control  of  a  substan- 
tial part  of  the  oil  output  of  the  state  have  urged  upon 
the  legislature  the  passage  of  a  law  which  would  enable 
the  state  to  stabilize  the  supply  of  petroleum  by 
requiring  a  franchise  or  certificate  before  new  wells 
could  be  developed. 

Surely  no  form  of  paternalism  has  been  urged  by 
those  aflBliated  with  the  public  utility  commissions 
commensurate  with  that  suggested  by  the  representa- 
tives of  these  vast  interests. 

IS  EQUIPMENT  NEXT? 

In  the  face  of  these  facts  and  in  the  knowledge  of 
the  existence  today  of  a  Federal  Trade  Commission, 
I  suggest  that  we  may  give  grave  consideration  to  the 
thought  of  calling  upon  government  to  regulate  those 
industries  that  control  in  monopoly  form  the  essen- 
tial materials  which  enter  into  public  utility  works. 
We  have  at  the  outset  a  request  from  a  portion  of  the 
industries  represented  in  public  utility  enterprises 
that  they  be  placed  under  government  supervision 
as  to  their  practices  and  their  rates.  It  would  require 
but  a  short  step  to  include  the  steel  industry,  the  equip- 
ment industries  which  provide  the  locomotives  and  the 
rolling  stock  for  the  railways;  and  the  electrical 
manufacturing  corporations  which  control  the  patents 
for  the  manufacture  of  the  electrical  machinery  of  the 
country. 

I  do  not  here  suggest  a  form  of  regulation  extending 
over  the  broad  field  of  industry.  Far  from  It.  The 
suggestion  embodies  but  little  more  than  has  already 
been  urged  by  the  industries  themselves.  The  purpose 
would  be  twofold.  First,  to  assure  a  proper  cost  to 
our  public  utility  enterprises  of  those  materials  which 
enter   into   their   construction,    and   hence   a   proper 


basis  of  honest  valuation;  second,  a  form  of  protection 
for  the  industry  itself,  safeguarding  it  against  the 
ravages  of  an  unrestricted  and  destructive  competition 
and  establishing  it  upon  a  solid  plane  of  liberal  profit 
and  rewards. 

COMMUNITY  RIGHTS  FIRST 

I  can  perceive  three  bases  of  protest  against  the 
suggestions  here  offered.  First,  of  course,  the  cry  of 
paternalism.  And  let  me  answer  that  the  need  of 
our  country  is  a  closer  co-operation,  a  more  spiritual 
understanding  of  our  needs,  a  deeper  appreciation  of 
our  liberties  and  a  keener  recognition  of  the  dangers 
to  which  they  are  incessantly  exposed.  We  can  not  be 
strong  without,  if  we  are  not  strong  within.  And  we 
can  not  be  strong  within  unless  we  are  united.  And 
we  can  only  unite  if  we  are  willing  gradually  to  learn 
the  lesson  that  the  right  of  the  individual  must  be 
merged  into  the  greater  right  of  the  community.  If  a 
greater  paternalism  be  needed  to  supply  the  remedy  for 
the  seething  industrial  unrest  and  to  curb  the  aggres- 
sions of  consolidated  wealth,  then  I  say,  let  us  have  the 
greater  paternalism. 

"The  old  law  of  supply  and  demand  no  longer  con- 
trols the  market  as  in  peace,"  said  Under  Secretary  of 
State  Arnold  Wahnschaffe  of  the  German  foreign  ofl5ce 
only  last  month.  "Governmental  regulation  has  re- 
placed this  law  in  order  to  prevent  too  high  prices  for 
the  poor.  Butter  prices  will  be  regulated  for  the 
empire  by  the  rules  of  Berlin,  promulgated  by  the 
Chancellor.  Maximum  prices  will  be  set  for  milk. 
The  needs  of  children,  ailing  mothers  and  the  sick  wiU 
be  specially  cared  for  through  sales  counters  and  special 
tickets.  Methods  also  will  be  taken  whereby  the 
poorer  portion  of  the  population  will  be  able  to  get 
meat  at  cheap  prices.  In  a  few  days  we  shall  forbid 
the  sale  of  meat  and  frying  with  fat  in  restaurants  for 
several  days  a  week,  and  so  regulate  the  consumption 
that  not  only  every  one  who  can  pay,  but  all  who  need 
them,  will  receive,  bread,  potatoes  and  all  other  foods." 

I  am  not  afraid  of  paternalism  in  American  industry 
and  I  am  willing  to  take  my  chances  in  this  republic 
with  any  danger  of  its  dedication  to  military  aggran- 
dizement. 

CAPITAL'S  RIGHT  TO  PROFITS 

The  second  objection  will  undoubtedly  embrace  the 
statement  that  capital,  being  timid,  will  be  frightened 
by  such  form  of  regulation,  and  will  cease  to  invest. 
The  obvious  answer  is:  first,  that  capital  can  not  cease 
to  invest.  It  must  invest  or  it  perishes;  second,  that, 
if  capital  may  be  assured  the  right  of  co-operation 
under  the  law,  with  a  further  right  and  assurance  of 
ample  profit  and  return,  capital  will  naturally  seek 


FINANCIAL    ASPECTS    OF    VALUATION 


169 


such  channel  of  investment;  third,  that  such  form  of 
regulation  is  the  suggestion  of  the  very  capital  to  be 
regulated;  and  fourth,  that  if  capital  persists  in  the 
alternative  of  the  right  to  govern  or  the  right  to  with- 
draw from  industry,  the  government  itself  must  fur- 
nish that  which  private  capital  may  refuse  to  supply. 

It  can  not  be  too  clearly  stated  nor  too  frequently 
emphasized  that  the  right  to  regulate,  far  from  meaning 
the  right  to  deprive  capital  of  an  adequate  return, 
should,  in  reality,  carry  with  it  the  obligation  to  pro- 
vide capital  with  generous  and  liberal  profit. 

Public  utility  development  should  not  lag  behind. 
It  should  lead  the  way.  And  any  public  authority 
which  adopts  a  niggardly  policy  toward  the  public 
utility  enterprises  in  its  midst  will  sooner  or  later  be 
struck  down  by  the  weapon  of  its  own  forging. 

Regulation  must  make  the  business  attractive  or 
regulation  fails.  If  regulation  focuses  itself  upon  nar- 
row considerations  of  6  per  cent,  7  per  cent  and  8  per 
cent,  or  any  other  set  return,  it  hoists  thereby  the 
flag  of  defeat.  Regulation  must  be  big  and  broad, 
and  it  must  realize  its  responsibility  in  keeping  un- 
checked the  flow  of  new  capital  into  regulated  enter- 
prises. 

NATION  SUPPLIES  LACK 

But  if  in  the  face  of  all  this,  private  capital,  insistent 
upon  its  right  to  command,  by  reason  of  its  force, 
should  still  refuse  to  invest,  it  is  then  incumbent  upon 
the  government  to  supply  the  deficiency  thus  created. 

Recently  the  United  States  government  enacted 
certain  legislation  affecting  the  American  merchant 
marine.  I  have  heard  representatives  of  steamship 
capital  state  that  the  law  was  highly  confiscatory.  I 
have  heard  representatives  of  the  seamen  insist  that 
the  law  was  merely  a  humane  measure  and  in  nowise 
calculated  to  cast  undue  or  improper  burdens  upon 
capital.  Capital  resorted  to  force  and  threat  to  require 
the  repeal  of  the  law.  Capital  withdrew  from  the 
steamship  service.  Faced  with  the  alternative  of 
yielding  to  the  demands  thus  made  or  of  itself  supply- 
ing the  service,  we  learn  from  Secretary  McAdoo  of 
the  Treasury  Department  that  the  government  itself 
will  undertake  the  steamship  business  for  the  country. 
"  Private  capital  says  it  can  not  undertake  the  service," 
asserts  the  secretary,  "therefore  it  is  incumbent  upon 
the  government  to  give  the  service. "  Accordingly  the 
next  Congress  will  consider  an  appropriation  of  $50,- 
000,000  for  a  great  national  public  utility  service;  the 
maintenance  of  a  merchant  marine. 


The  third  objection  to  be  urged  will  be  the  check 
which  regulation  may  have  upon  the  inventive  and  the 
enterprising  genius  of  the  country.  Those  who  will  urge 
this  most  insistently  rely  upon  their  fundamental  phil- 
osophy that  the  whole  mainspring  of  human  effort  is 
profit.  It  is  notorious  that  a  very  large  part  of  the 
inventive  genius  of  the  country  is  absorbed  by  the  cor- 
poration which  by  standing  contract  possesses  itself  of 
the  patents  which  its  employees  may  evolve.  But  there 
is  something  still  deeper  than  this.  Inventiveness  and 
enterprise  rest  upon  motives,  not  only  material,  but 
spiritual.  History  shows  there  has  been  an  intensity 
of  satisfaction  in  service  as  well  as  in  material  reward. 

Nor  am  I  speaking  idly  nor  in  platitudes,  for  the 
record  of  things  done,  inventions  made,  will  bear  me 
out. 

But  regulation  never  has  and  never  should  withdraw 
the  reward  for  enterprise  and  inventive  genius.  It  has, 
on  the  contrary,  specially  insisted  that  it  be  ever  present 
and  liberally  bestowed. 

HUMANITY  MUST  GOVERN 

In  conclusion,  and  by  way  of  summary,  let  me  sug- 
gest: first,  that. we  keep  a  constant  eye  upon  the  ulti- 
mate purpose  of  valuation;  second,  that  we  eliminate 
the  illegitimate  profit  and  the  breach  of  trust;  third, 
that  we  be  not  misled  into  "original  cost"  when  we 
have  in  mind  "reasonable  cost";  and  fourth,  that  we 
urge  upon  government  a  closer  control  of  credit;  fifth, 
that  we  give  heed  to  the  necessity  of  regulations  of 
public  utility  materials  under  monopoly  ownership;  and 
sixth,  that  We  strengthen  the  hands  of  government 
to  perform  the  public  utility  service  which  private 
capital  can  not  be  induced  to  furnish  on  fair  terms. 
Then,  and  only  then,  will  we  attain  to  a  clear  and 
logical  basis  of  valuation. 

Finally,  let  me  urge  upon  you  that  valuation  be  made 
a  forward  looking  thing.  Let  it  be  approached  as  a 
problem  of  government,  with  a  fixed  eye  upon  the  co- 
ordination of  our  industries  to  the  needs  of  our  people, 
with  a  broad  spirit  and  a  far  vision.  Those  who  have 
undertaken  this  work  have  assumed  a  solemn  duty. 
It  is  not  lightly  to  be  tossed  aside  with  judicial  and 
technical  decision  fitted  to  the  needs  of  the  instant. 
It  must  be  met  and  measured  by  the  needs  of  humanity. 
The  nation  which  built  the  Panama  Canal  and  contem- 
plates its  own  merchant  marine  need  not  falter  in  the 
face  of  the  present  issue. 


170 


THE      UTILITIES      MAGAZINE 


FINANCIAL  ASPECTS  OF  REGULATION 

By  Robert  C.  Wood 

Public  Service  Commissioner  for  the  First  District,  Slate  of  New  York 


We  have  heard  at  the  proceedings  of  this  Conference  most 
able  and  interesting  discussions  relating  to  the  various 
methods  of  obtaining  the  valuation  of  public  utility  proper- 
ties. We  have  also  heard  discussed  at  length  the  necessity 
of  making  proper  allowances  for  the  various  phases  of 
depreciation. 

I  believe  that  about  these  two  questions  lie  the  most 
important  factors  of  regulation  not  only  for  determining, 
but  alteo  for  maintaining,  the  value  of  public  utility  proper- 
ties. Also  that  upon  their  proper  solution  depend  not 
only  to  a  great  extent  the  value  of  existing  securities,  but 
also  the  conditions  under  which  new  capital  can  be  obtained 
for  our  public  utility  corporations. 

Much  as  our  views  may  vary  regarding  the  methods  to  be 
employed  in  regard  to  the  valuation  and  maintenance  of 
these  properties  I  think  we  can  all  agree  that  the  objects 
we  want  to  attain  by  the  regulation  of  public  utility  com- 
panies are: 

(1)  a  fair  rate  to  the  public 

(2)  a  fair  return  on  the  capital  invested 

(3)  that  the  corporation  should  be  in  a  position  where 
it  can  obtain  from  time  to  time  the  capital  it  needs  to  provide 
the  additional  facilities  that  the  public  may  demand. 

I  believe  that  the  principle  of  state  regulation  of  these 
corporations  has  become  firmly  established  and  that  this 
regulation  has  encouraged  and  protected  their  development 
along  lines  proper  and  necessary  to  the  communities  which 
they  serve.  Competition  between  public  utility  corporations 
is  rapidly  becoming  eliminated  and  has  been  succeeded  by  a 
strict  regulation  of  all  the  acts  of  these  corporations  by  state 
public  service  commissions. 

W^hile  commissioners  of  different  states  may  now  hold 
somewhat  conflicting  views,  the  general  tendency  is  to 
standardize  certain  fundamental  rules  and  regulations  par- 
ticularly those  relating  to  the  appraisal  and  maintenance 
of  public  utility  prof)erties.  Unfortunately,  we  are  a  long 
way  yet  from  anything  like  a  universal  agreement  on  these 
fundamentals,  and  this  process  of  standardization  is  still  in 
a  state  of  development.  The  rules  and  regulations  of  the 
various  public  service  commissions  are,  however,  gradually 
crystallizing  toward  a  common  basis. 

It  would  seem  that  there  are  certain  fundamental  facts 
that  will  be  admitted  by  all. 

1.  That  the  policy  and  principle  of  the  regulation  of 
public  utility  properties  by  public  service  commissions  have 
come  to  stay.  A  large  majority  of  the  states  of  the  Union 
have  adopted  it. 

2.  That,  if  this  system  of  regulation  is  properly  and 
logically  carried  out  and  enforced,  both  the  public  service 
corporations  and  the  public  whom  they  serve  wiU  be  mu- 
tually benefited. 


3.  The  investor  should  receive  a  fair  and  reasonable  rate 
of  return  on  his  investment. 

It  is  the  function  of  regulation  to  determine  the  value  of 
the  investment  in  the  property  in  order  to  ascertain  the  basis 
for  a  reasonable  rate  of  return. 

Regulation  as  universally  accepted  should,  I  believe,  mean 
that  the  investment  must  be  protected  against  depreciation. 
Valuation  as  a  step  in  regulation  involves  the  inventory  of 
the  property,  the  determination  of  its  condition  and  thus 
makes  possible  the  accurate  ascertainment  of  depreciation 
charges.  Proper  regulation  prevents  the  use  of  corporate 
funds  for  the  payment  of  dividends  at  the  expense  of  main- 
tenance or  by  failure  to  take  adequate  measures  against 
the  inevitable  effects  of  age,  decay  and  the  "change  of  the 
art."  By  thus  maintaining  operating  efficiency  and  con- 
sequent continued  earning  power,  properties  are  safeguarded 
in  the  interest  of  proper  service  to  the  public,  as  well  as 
equally  safeguarded  in  the  interest  of  the  investor. 

The  latter  should  be  assured  that  proper  allowances  are 
being  made  from  operating  revenues  for  renewals  and 
replacements  of  the  property,  so  that  the  plant  and  equip- 
ment can  be  renewed  as  fast  as  they  fail  to  render  eflScient 
service.  In  this  way  a  high  degree  of  efiiciency  should  be 
preserved,  and  the  investor  assured  that  the  full  value  of 
his  property  will  be  maintained. 

Regulation  further  means  proper  accounting  and  publicity 
in  accounts.  The  utifity  must  make  reports  to  the  com- 
mission and  these  reports  are  public  documents.  There  can 
be  no  secrecy  as  to  earnings  and  profits.  The  extent  of  the 
property  the  company  owns  is  clearly  defined.  There  can 
be  no  financial  jugglery  or  abuse  of  the  confidence  of  the 
investing  public  by  promoters  or  managers  as  has  at  times 
unfortunately  happened  in  the  past.  The  corporation  in 
turn  should,  through  being  allowed  to  charge  a  fair  and 
equitable  rate,  be  in  a  position  to  attract  such  new  capital 
as  it  requires  from  time  to  time  for  extensions  and  improve- 
ments. In  this  way  only  can  it  furnish  the  public  with 
such  facilities  as  it  needs. 

Every  public  utility  corporation,  be  it  a  gas,  electric  light 
company,  or  a  street  railway  company,  does  its  share  in 
the  development  of  the  locality  it  serves,  provided  the 
service  it  renders  the  public  is  adequate  and  its  charges  are 
reasonable.  Every  community  is  dependent  upon  its  light- 
ing, transportation,  telephone  and  telegraph  facilities  for  its 
development  and  is  vitally  interested  in  the  quality  of 
service  it  receives. 

As  both  the  corporation  and  the  public  are  so  deeply 
interested  in  each  other's  welfare,  it  can  be  easily  seen  that 
a  fair  and  reasonable  equilibrium  must  be  maintained  between 
them.  If  the  locality  or  section  served  is  a  rapidly  growing 
one,  it  continually  requires  more  and  more  lighting  and 
transportation  facihties.     In  fact,  it  caimot  reach  its  maxi- 


MAKING    AND    MAINTENANCE    OF    INVENTORIES 


171 


mum  development  without  them.  In  a  developed  neighbor- 
hood, also,  the  public  is  interested  in  having  these  facilities 
maintained  at  their  maximum  efficiency;  otherwise,  the 
prosperity  of  the  section  would  be  seriously  impaired.  The 
corporation,  on  the  other  hand,  is  vitally  interested  in  the 
prosperity  of  the  territory  it  serves,  and  if  its  management 
is  progressive,  it  should  do  everything  in  its  power  to  render 
adequate  service  at  reasonable  rates.  In  order  to  accomplish 
this  the  plants  must  be  maintained  at  a  high  state  of  efficiency 
and  a  proper  allowance  be  made  annually  for  the  various 
phases  of  depreciation. 

It  is  a  well  known  fact  that  a  public  utility  corporation 
never  stands  still.  It  continually  requires  new  capital. 
Moreover,  the  growth  and  development  of  the  territory  it 
serves  often  demand  expenditures  considerably  in  advance 
of  a  reasonable  return  on  the  capital  invested.  "The 
advance  in  the  state  of  the  art,"  especially  the  electrical  art, 
is  continually  requiring  that  machinery,  equipment,  etc., 
be  superseded  by  a  newer  and  more  up-to-date  plant  and 
equipment.  The  corporation  should  be  encouraged  to  make 
these  improvements,  and  so  long  as  it  furnishes  proper  and 
adequate  service,  should  be  permitted  to  earn  a  reasonable 
return  on  its  investment. 

It  should  be  the  aim  of  regulation  to  enable  corporations. 


through  the  fair  valuation  of  their  properties  and  through 
a  fair  return  on  their  value  to  make  investment  in  their 
securities  safe  and  attractive.  Here  the  interest  of  the  pub- 
Uc  and  the  interest  of  the  corporation  are  one  and  the  same. 

In  a  word,  the  public  needs  the  utility  corporations  and  is 
as  much  interested  in  their  ability  to  properly  discharge 
their  duties  as  are  the  corporations  in  turn  interested  in  the 
welfare  and  development  of  the  localities  they  serve. 

I  believe  that  under  public  service  commission  regulation 
the  securities  of  a  corporation  having  an  established  earning 
capacity,  a  capitalization  within  the  limits  of  a  fair  and 
reasonable  valuation  of  its  property  and  under  specific 
requirements  for  setting  aside  annually  from  operating 
revenues,  proper  allowances  for  renewals  and  replacements, 
should  prove  safe  and  desirable  investments. 

It  is  well  established  that  proper  regulation  of  these 
properties  has  already  created  a  feeling  of  increased  con- 
fidence in  investment  circles.  I  have  noticed  with  interest 
for  some  time  past  the  more  favorable  attitude  of  the  Invest- 
ment Bankers  Association  and  other  investment  interests 
toward  public  utility  securities.  Also,  that  financial  houses 
in  making  offerings  of  securities  now  almost  invariably,  I 
might  say,  wherever  possible,  make  and  emphasize  the 
statement  "approved  by  the  Public  Service  Commission." 


THE   MAKING  AND  MAINTENANCE  OF   PRICED  INVENTORIES  OF 

PUBLIC  UTILITIES 

By  Charles  L.  Pillsbury 

Chief  Engineer,  Valuation  Bureau,  Public  Utilities  Commission,  District  of  Columbia 


MANY  elements  enter  into  that  vague  and  indef- 
inite quality,  value — of  public  utility  prop- 
erties. Many  moot  principles  are  involved 
and  are  likely  to  continue  to  be  involved  for  some  time 
to  come.  Few,  indeed,  of  the  host  of  economists, 
engineers,  lawyers  and  public  utility  specialists,  con- 
stantly grappling  with  the  problems,  are  so  sanguine  as 
to  predict  any  general  clarification  of  the  subject  before 
the  lapse  of  years,  with  even  the  main  principles  well 
settled  in  equity  and  law. 

Under  such  circumstances,  it  is  not  at  all  surprising, 
though  none  the  less  unfortunate,  that  great  lack  of 
uniformity,  and  agreement  as  to  methods,  now  pervades 
practically  all  phases  of  the  intricate,  laborious  and 
costly  processes  of  setting  up  value,  and  especially  of 
that  most  laborious  process,  the  making  and  pricing 
of  inventories.  Much  unnecessary  duplication  and 
many  economic  wastes  are  involved  which  in  the  end 
the  public  must  pay  for.  One  of  the  most  important 
services  which  this  Utilities  Bureau  can  perform  is  that 
of  helping  to  bring  into  the  open  and,  so  far  as  practi- 
cable, standardize  methods  of  procedure.     It  is  with 


this  idea  in  view,  as  to  inventories,  that  this  paper  is 
prepared. 

The  purpose  of  this  paper  is  to  call  attention  to  a  few 
of  the  basic  features  of  the  making  and  pricing  of 
inventories :  the  lack  of  uniform  methods  and  standard- 
ization; the  economic  wastes  of  duplication,  repetition 
and  lack  of  uniformity;  the  detail  submitted  and  sub- 
merged; the  futility  of  attempting  to  compare  the  items 
or  costs  of  one  with  another  without  a  specific  knowl- 
edge of  all  of  the  facts  involved;  and  the  desirability 
of  the  making  of  inventories  so  that  they  can  and  will 
be  maintained.  The  subject  is  very  broad  and  any 
attempt  at  specific  discussion  of  all  of  these  matters, 
or  of  the  detail  of  inventory  making,  would  be  pre- 
sumptuous and  impracticable  here.  The  making  of  a 
valuation  may  be  likened  to  the  tracing  of  a  tall  and 
spreading  tree ;  no  matter  which  branch  we  take  at  each 
succeeding  fork  another  fork  lies  just  ahead.  The  idea 
here  is  only  to  call  attention,  largely  indirectly  or  by 
suggestion  under  more  or  less  specific  headings,  to  the 
matters  referred  to,  in  the  hope  that  discussion  and  per- 
haps future  more  specific  papers  by  others  may  bring 
forth  fruitful  results. 


172 


THE      UTILITIES      MAGAZINE 


PART  IX 

THE    MAKING    AND    MAINTE 
NANCE  OF  PRICED  INVEN- 
TORIES 


PURPOSE  OF  VALUATION  AND  INVENTORY 

Inventories  of  mercantile  establishments  and  indus- 
trial plants  are  made  for  the  purpose  of  finding  the 
worth  of  the  owner,  as  an  adjunct  to  the  annual  bal- 
ance sheet;  for  the  guidance  of  investors  in  stock  and 
bonds;  for  establishing  and  maintaining  credit;  as  a 
basis  for  sale,  consolidation  or  liquidation  of  debts;  as  a 
basis  for  economic  management;  for  insurance  adjust- 
ment, etc. 

Valuations  and  inventories  of  public  utility  proper- 
ties are  made  for  a  number  of  purposes  which  have  been 
generalized  as : 

1.  Purchase,  transfer  or  consolidation. 

2.  Franchise  and  other  public  negotiations. 

3.  Capitalization  or  issuance 
and  approval  of  securities. 

4.  Rate  adjustment. 

5.  Taxation. 

6.  Corporate  expediency. 
The  first  five  purposes  are 

generally  understood.  The 
sixth,  corporate  expediency,  has 
been  almost  universally  under- 
estimated by  both  the  public 
and  the  corporations.  A  prop- 
erly compiled  basic  inventory 
and  valuation  may,  with  ad- 
justments, be  adapted  to  many 
special  uses  of  great  advantage 
to  the  owner,  as  for  instance 
the  following  (based  on  a  recent 
utterance  of  Mr.  H.  P.  Gillette) : 

A.  Guidance  of  investors  in 
stock  and  bonds. 

B.  Guidance  of  holding  com- 
panies and  of  managers  in  comparing  operating  statis- 
tics, costs  and  earnings  of  one  plant  with  another. 

C.  Guidance  of  management,  purchasing  and  engi- 
neering departments  in  detecting  and  avoiding  errors  of 
design,  purchase  and  construction,  and  by  providing 
for  quick  reference,  intimate  details  of  all  parts  of  the 
property. 

D.  As  a  basis  for  estimating  accrued  depreciation 
and  more  especially  depreciation  reserve. 

E.  As  a  guide  to  the  purchasing,  accounting  and 
engineering  departments  in  setting  up  and  maintaining 
proper  analyses  of  costs. 

F.  As  a  basis  for  insurance  adjustments. 

It  would  certainly  appear  that  the  usages  are  more 
varied,  and,  on  the  whole,  more  important  in  the  case 
of  public  utilities  than  in  the  case  of  industrials.  In 
the  latter  only  the  management,  debtors  and  creditors 
have  an  interest;  in  the  former,  these  interests  should 
be  as  great,  and  there  is  also  the  most  important  public 


WASTES  IN  INVENTORYING 

THE  imED  FOR  STANDARDIZATION 

THE  MAKING  OF  INVENTORIES 

THE  MAINTENANCE  OF  INVENTORIES 

SOME  ESSENTIALS  OF  APPRAISAL  WORK 

ORGANIZATION  AND  CLASSIFICATION 

OVERHEAD  CHARGES 

CO-OPERATION    IN   MAKING   INVENTORIES 

THE  IMPORTANCE  OF  MAINTAINING  PRICED 
INVENTORIES 


interest  as  well.  And  yet  the  need  of  the  making  and 
maintenance  of  industrial  inventories  has  long  been 
recognized,  while,  on  the  other  hand,  public  utility 
inventories  have  in  too  many  cases  been  studiously 
avoided  as  unnecessary  evils.  These  differing  attitudes 
are,  doubtless,  due  in  part  to  the  much  greater  com- 
plexity and  indefiniteness  of  public  utility  inventories 
and  valuations.  The  more  or  less  unity  of  interests  in 
industrial  appraisals  eliminates  the  array  of  acute  moot 
principles  which,  by  reason  of  the  public  interest,  are 
involved  in  public  utility  appraisals.  And,  further- 
more, the  intricatenesses  of  the  properties  themselves 
and  especially  of  the  complex  labor  items  involved,  are, 
in  general,  vastly  less  in  the  case  of  industrials.     Still 

again,  since  litigation  affecting 
confiscation  of  property  is  sel- 
dom involved  in  industrial  ap- 
praisals, usually  much  less  detail 
is  required. 

Referring  now  to  public  util- 
ity valuation,  we  are  confronted 
with  the  fact  that  both  the  value 
to  be  derived  and  the  property 
to  be  included  depend  upon  the 
specific  purpose  of  the  valua- 
tion. Since  both  property  and 
value  will  vary  with  the  differ- 
ent purposes  it  is  essential  that 
the  appraiser  has,  at  the  outset, 
a  clear  understanding  of 

First :  The  purpose  of  the  in- 
vestigation, and 

Second:  The  application  of 
the  inventory. 

Upon  the  purpose  of  the  in- 
vestigation will  depend  the  property  to  be  included  and 
excluded  and  the  character  of  the  value  or  "amount" 
finally  to  be  ascertained.  Upon  the  specific  application 
of  the  inventory  in  the  process  of  finding  value  will 
depend  the  details  of  the  inventory  and  the  nature  of 
the  individual  costs  or  values  to  be  assigned  to  it. 

The  appraiser  must  first,  therefore,  have  a  clear 
conception  of  the  limitations  with  respect  to  each  valua- 
tion purpose.  If,  for  instance  the  valuation  is  for  the 
purpose  of  a  rate  adjustment,  then  the  property  is  to 
be  limited  to  that  "used  and  useful  in  the  service  of  the 
public,"  and  a  clear  conception  must  be  had  as  to  what 
is  used  and  useful  and  what  is  not.  An  excessively 
overbuilt  plant,  for  instance,  unnecessarily  large  for 
present  and  near  future  use,  may  not  in  entirety  be  a 
basis  for  rates  and  a  certain  portion  of  such  property  or 
of  the  value  thereof  may  be  excluded.  Land  in  excess 
of  that  actually  in  use  may  or  may  not  be  useful.  It 
may  or  may  not  represent  wise  and  strategic  purchase 


MAKING    AND    MAINTENANCE    OF    INVENTORIES 


173 


for  future  need.  Many  such  questions  pertaining  to 
property  to  be  included  and  excluded  must  be  held  in 
mind  and  analyzed,  but,  regardless  of  the  nature  of  the 
investigation,  all  physical  property  should,  neverthe- 
less, be  inventoried — inventoried  and  then  segregated 
into  property  included  and  excluded  respectively.  This 
for  two  reasons:  First,  so  that  the  report  will  show 
clearly  what  has  been  included  and  what  excluded,  the 
reasons  therefor,  and  the  detailed  nature  and  extent 
of  both;  thus  enabling  full  consideration  to  be  given  to 
these  matters  in  the  final  determination  of  "fair  value" 
or  "fair  amount"  for  the  purpose  in  hand.  Second, 
so  that  the  inventory  may  to  the  fullest  extent  justify 
its  costs;  that  is,  so  that  it  may  later  on,  as  nearly  as 
possible,  be  adapted  to  any  of  the  possible  usages  and 
be  maintained  to  that  end. 

Aside  from  the  immediate  purpose  of  the  valuation, 
the  inventory  itself  may  be  applied,  in  the  process  of 
finding  value,  in  several  ways,  as  for  instance: 

1.  As  an  adjunct  to  an  investigation  from  the  books 
and  records  of  the  company,  of  actual  cost  or  so-called 
historical  cost  or  investment. 

2.  For  the  purpose  of  estimating  past  cost  by  apply- 
ing to  the  present  inventory  actual  and  estimated  costs 
of  the  past,  corresponding  to  the  respective  periods  of 
actual  construction. 

3.  For  the  purpose  of  attempting  to  directly  derive 
fair  value  for  the  purpose  in  hand  according  to  the 
theory  or  belief  of  the  appraiser  by  distinctly  following 
neither  actual  cost  nor  estimated  actual  cost  nor  cost 
of  reproduction,  but  by  assuming  modifications  of  any 
or  all  of  these  elements  of  value,  based  on  engineering, 
legal  or  economic  considerations. 

1.  Actual  Cost  Method.  All  actual  cost  investiga- 
tions from  the  books  and  records  should  be  supple- 
mented by  inventories  of  the  physical  properties. 
The  books  and  records,  even  if  containing  complete 
cost  or  investment  accounts  which  is  rare,  seldom,  if 
ever,  contain  a  specific  record  in  requisite  detail  of  the 
property  owned  or  of  the  property  now  "used  and  useful 
in  the  service  of  the  public,"  nor  sufficient  information 
upon  which  to  determine  that  most  perplexing  question, 
depreciation.  Nor  sufficient  proof  of  the  true  net 
costs  without  some  verification  by  estimate. 

Such  an  inventory  should  be  made  jointly  with,  or  so 
as  to  harmonize  with,  the  accounting  investigation. 
The  detail  need  only  be  to  such  extent  as  the  book 
costs  are  detailed  or  as  necessary  for  identification  and 
verification.  Such  an  inventory  is  usually  compara- 
tively simple.  It  will  be  of  little  or  no  value  for  other 
purposes. 

2.  Estimated  Past  Cost  Method.  Priced  inventories 
of  existing  properties  are,  so  far,  seldom  used  as  a  basis 
for   estimating   past   costs,    although   this   method   is 


advocated  by  many.  The  necessary  detail  and  arrange- 
ment of  such  an  inventory  will  depend  largely  upon  the 
nature  and  details  of  the  actual  costs  known  and  those 
to  be  estimated.  If  prepared  specifically  for  this  pur- 
pose, the  inventory  will  usually  be  of  little  value  for 
other  purposes. 

3.  Cost  of  Reproduction  Method.  The  principal  use 
to  date  of  inventory  in  valuing  public  utilities  is  that 
of  cost  of  reproduction.  It  seems  at  present  to  be 
pretty  well  established  in  law  that  cost  of  reproduction 
is  a  necessary  and  pertinent  element  in  the  determina- 
tion of  value.  In  many  cases  it  has  been  taken  as  the 
prepondering  element,  although  in  such  cases  undoubt- 
edly given  greater  weight  than  would  have  obtained 
had  actual  cost  been  capable  of  more  accurate  deter- 
mination. The  importance  of  cost  of  reproduction  as 
an  element  of  value  as  indicated  by  the  acts  of  Congress 
with  respect  to  the  stupendous  task  of  valuing  the  com- 
mon carriers  now  under  way  by  the  Interstate  Com- 
merce Commission,  and  also  with  respect  to  the  valua- 
tion of  the  public  utilities  of  the  District  of  Columbia 
under  the  Public  Utilities  Commission  of  the  District, 
cost  of  reproduction  as  well  as  actual  cost  and  other 
elements  being  specifically  required  by  the  acts. 

A  cost  of  reproduction  inventory  properly  detailed 
and  segregated  may,  with  modifications,  be  adapted  to 
many  other  purposes. 

4.  Modification  Method.  Application  four  (the  at- 
tempt on  the  part  of  the  appraiser  to  derive  fair 
value  directly)  is  not  to  be  advocated  except  for  the 
purpose  of  approximation  only,  and  only  in  cases  not 
involving  court  litigation  over  the  matter  of  confiscation 
of  property.  And  when  adopted  as  a  modification  of 
cost  of  reproduction,  it  is  far  better  to  set  up  cost  of 
reproduction  in  entirety,  and  then  apply  the  advocated 
modifications  and  substitutions  and  give  the  reasons 
therefor.  The  result  is  much  more  apt  to  be  logical 
and  fair  and  the  modifications  are  then  open  for  review 
by  others,  and,  furthermore,  the  inventory  can  then 
best  be  maintained  for  other  usages. 

This  may  not  be  clear.  My  idea  is  that  so  long  as 
it  seems  to  be  established  in  law  (through  precedence 
of  court  decision  or  otherwise)  that  the  fair  value  or 
amount  to  be  derived  involves,  among  other  elements 
cost  of  reproduction  as  well  as  actual  cost,  as  distinct 
elements  of  value  the  appraiser  should  first  set  up  as 
distinctly  as  possible  these  separate  elements.  And 
then  if  it  so  happens  that  he  is  also  to  perform  the 
judicial  functions  of  arriving  at  fair  value  or  amount 
for  the  purpose  in  hand  or  is  to  express  his  opinion  of 
such  fair  value  this  judicial  process  on  his  part  of  sub- 
stitution, elimination,  enhancement,  etc.,  should  follow. 
He  should  not  still  further  confuse  an  already  too  con- 
fused matter  by  following  his  own  dictates  throughout 


174 


THE      UTILITIES      MAGAZINE 


the  entire  process  of  appraisal  and  valuation.  Such  a 
method  merely  constitutes  a  basis  for  opinion  testimony. 
If  cost  of  reproduction  is  the  purpose  of  the  inven- 
tory, then  the  appraiser  must  have  clearly  in  mind 
throughout  that  he  is  not  ascertaining  value  but  merely 
an  important  element  of  value.  There  would  not  be 
so  much  criticism  of  cost  of  reproduction  if  this  basic 
principle  were  more  generally  understood.  The  prices 
or  monetary  figures  to  be  applied  to  the  inventory  items 
and  groups  of  items  are  not  therefore  to  represent 
values,  nor  past  costs,  nor  even  present  costs,  except 
where  such  costs  coincide  with  costs  of  reproduction. 
The  appraiser  must  conceive  of  a  logical  and  humanly 
possible  process  of  reproduction  and  he  must  be  con- 
sistent throughout. 

PRELIMINARY  INVESTIGATION 

At  the  outset  of  any  inventory  and  appraisal  of  a 
public  utility  property  for  any  purpose,  the  appraiser 
should  acquaint  himself,  as  thoroughly  as  possible,  with 
the  extent,  location,  and  general  character  of  the  prop- 
erty, its  physical  (and  when  possible,  its  financial)  his- 
tory, its  mode  of  operation  and  its  special  peculiarities. 

The  proper  organization,  program  of  procedure,  and 
grouping  of  items  will  depend  largely  upon  such  pre- 
liminary study. 

CO-OPERATION 

All  inventories  for  public  purpose  should  be  the 
result  of  frank,  sincere  and  friendly  co-operation 
between  the  corporation  and  the  public.  This  particu- 
larly appUes  to  the  unpriced  inventory  of  physical 
property,  and,  in  most  cases,  many  of  the  base  costs  at 
least  to  be  applied  to  the  inventory  can  and  should  be 
established  jointly.  The  inventory  of  physical  items 
should  be  a  matter  of  fact,  not  of  controversy.  There 
is  no  reason,  other  than  those  born  of  distrust  or 
antagonism  on  the  part  of  the  parties  at  issue,  or  selfish 
motives  on  the  part  of  engineers  and  attorneys,  why  a 
rate  case,  for  instance,  should  be  complicated  and 
delayed  by,  and  burdened  with  the  heavy  excess  cost  of 
litigation  over  such  matters  as  the  number  of  brick  in 
a  given  building  or  the  pounds  of  copper  in  an  electrical 
system.  These  are  matters  of  fact,  and  where  the  facts 
are  somewhat  difficult  of  ascertainment,  in  nine  cases 
out  of  ten,  the  matter  would  be  settled  more  fairly  to 
both  parties  and  with  vastly  less  expenditure  of  time 
and  money  if  adjudicated  in  the  field  instead  of  in  a 
court  of  law  or  at  a  commission  hearing. 

Appraisals  can  be  made,  and  are  being  made,  for  the 
public  with  complete  lack  of  company  co-operation,  but 
such  cases  are  rare.  When  encountered,  and  especially 
where  the  property  is  comparatively  large  and  intricate 
and  available  records  vague  and  incomplete,  as  is  usually 


the  case,  a  detailed  appraisal  is  only  made  at  great  sac- 
rifice of  time  and  expense  and  with  much  liability  of 
error. 

As  a  matter  of  fact,  nearly  all  fairly  made  and  reason- 
ably accurate  public  appraisals  are  more  or  less  depend- 
ent upon  partial  company  co-operation.  It  is  certainly 
better  to  have  full  co-operation  than  for  either  side  to 
base  any  of  its  conclusions  on  half-hearted  and  suspi- 
cious partial  co-operation  with  facts  half  revealed 
and  half  concealed. 

It  is  not  necessary  in  such  co-operation  that  an  arbi- 
trator be  appointed.  Most  questionable  matters  of 
inventory  and  basic  features  and  facts  of  imit  costs 
will  be  quickly  and  fairly  settled  by  the  respective 
engineers  in  charge.  And  such  matters  as  can  not  be 
readily  settled  in  this  manner  may  well  be  set  up  dif- 
ferently by  the  two  parties  for  final  adjudication.  A 
vast  number  of  the  items  will  at  least  have  been  elimi- 
nated from  final  disagreement  and  the  inventories  will 
in  all  respects  be  on  a  directly  comparable  basis. 

The  usual  independent,  dissimilar,  competitive  in- 
ventories result  in  excessive  economic  waste  by  reason 
of: 

First:  Duplication  of  cost  of  inspection  and  com- 
pilation. 

Second :  Added  cost  of  laborious  and  difficult  check- 
ing and  defending  of  inventories  prepared  on  different 
bases  both  as  to  property  and  costs  and  with  different 
itemization,  grouping  and  arrangement. 

Third:  Unnecessary  detail  of  each  in  order  that  it 
may  equal  or  outweigh  the  other. 

This  economic  waste  is  borne  entirely  by  the  public. 
The  public  pays  directly  for  its  own  portion  and  the 
rate  payers  in  the  end  pay  the  company's  costs. 

ORGANIZATION 

Proper  organization  is  of  prime  importance.  The 
size  and  character  of  the  organization  will  naturally 
depend  upon  the  size  and  character  of  the  property  to 
be  appraised,  but  in  most  comparatively  large  under- 
takings the  varied  nature  and  intricateness  of  the  prop- 
erty will  require  specialization  and  the  division  of  the 
work  into  certain  natural  engineering  divisions  such  as, 
for  illustration,  track  and  roadway,  buildings  and  struc- 
tures, roUing  stock,  power  plant  and  substation  equip- 
ment, electrical  distribution,  cost  analysis,  etc.,  together 
with  a  statistical  and  clerical  department,  and  an 
accounting  force. 

Cost  data  should  be  compiled  largely  by  the  respec- 
tive departments,  in  order  to  utilize  to  the  fullest  ex- 
tent specialized  knowledge  and  experience,  but,  so  far 
as  practicable,  should  be  finally  analyzed,  compared, 
arranged  and  filed  by  a  cost  analysis  department,  which 
department  should  especially  interest  itself  in  all  costs 


MAKING    AND    MAINTENANCE    OF    INVENTORIES 


175 


which  are  of  general  application,  applying  to  several 
departments  or  divisions  of  the  work,  thus  so  far  as 
practicable  unifying  the  whole  and  avoiding  discrep- 
ancies. 

It  is  of  the  utmost  importance  that  the  organization 
not  only  be  fitted  for  the  work  individually  but  also 
work  harmoniously  as  a  unit,  toward  one  end,  and  with 
frequent  interchange  of  ideas  so  as  to  insure  a  broad 
view  point  and  an  unbiased  attitude  throughout. 

With  any  organization  specific  and  detailed  instruc- 
tions are  necessary  at  the  outset  in  order  that  sharp 
lines  of  demarkation  may  be  drawn  between  the  work 
of  the  different  departments,  thus  avoiding  duplication 
and  omission.  Thorough  systematization  of  the  entire 
work  is,  of  course,  a  necessity,  as  the  details  to  be  han- 
dled in  a  large  undertaking  of  this  character  are  almost 
beyond  behef  in  number  and  intricateness. 

CLASSIFICATION 

It  is  very  essential  that  the  inventory  and  valuation 
be  compiled,  filed  and  finally  set  forth  in  logical,  orderly 
and  systematic  manner.  The  first  requisite  of  this  is 
the  division  of  the  property  into  specified  classifica- 
tions. These  classifications  should  correspond  with 
the  capital  account  classifications  of  a  proper  account- 
ing system.  Uniform  classification  for  similar  proper- 
ties is  highly  desirable  in  order  that  proper  comparisons 
may  be  made  both  as  to  accounting  and  operating 
records,  and  as  to  appraisals  of  different  companies. 

The  Interstate  Commerce  Commission  has  pre- 
scribed classifications  for  all  common  carriers,  and  for 
the  public  utilities  of  the  District  of  Columbia,  and  the 
various  State  Commissions  have  prescribed  classifica- 
tions for  the  utilities  operating  in  their  respective  states. 
Unfortunately,  these  various  classifications  are  not  uni- 
form.    Standardization  should  begin  here. 

SECTIONS 

The  property  under  each  classification  should,  for 
convenience  in  inventorying,  be  divided  into  sections 
according  to  location.  Classifications  pertaining  to 
power  plants,  for  instance,  should  be  so  divided  as  to 
set  forth  the  details  and  totals  separately  for  each  plant 
and  each  natural  division  of  plant.  The  matter  of  sec- 
tionalizing  is  particularly  important  in  the  case  of 
large  track  systems,  electrical  distribution  systems,  and 
other  property  covering  considerable  area  with  no  def- 
inite natural  location  divisions.  The  underground  elec- 
trical distribution  system  in  a  large  city,  embracing 
thousands  of  manholes  and  many  miles  of  conduit  and 
cables  interlaced  into  a  complicated  net  work  with  no 
natural  lines  of  demarkation,  would  be  exceedingly 
difficult  to  inventory  in  the  field,  without  omission  and 
duplication,  unless  first  arbitrarily  divided  into  many 


small  sections,  comparatively  simple  individually,  and 
with  all  limits  clearly  and  sharply  defined. 

The  permanent  value  of  an  inventory  and  the  ease  of 
an  incentive  to  its  maintenance  will  greatly  depend 
upon  the  sectionalizing  of  the  various  property  classi- 
fications. 

RELATIONSHIP  OF  ITEMS 

Great  care  must  be  exercised  in  determining  the  divi- 
sion of  classification  section  into  items  and  the  relation- 
ship of  the  items  to  each  other.  Both  costs  and  depre- 
ciation must  be  kept  in  mind.  The  relationship  must 
be  commensurate  with  actual  construction  process  and 
with  such  processes  as  would  obtain  in  the  reproduction 
conceived.  The  items  and  their  relationship  must 
harmonize  with  the  analyses  of  costs  and  the  unit  costs 
derived.  The  division  and  arrangement  should  be  such 
as  to  facihtate  accurate  depreciation  calculations  with- 
out rearrangement  for  the  purpose.  Items  which 
depreciate  differently  should,  therefore,  so  far  as  prac- 
ticable, be  set  forth  independently,  and,  where  practi- 
cable, age,  also,  should  be  taken  into  account  in  the 
separation  of  items.  The  importance  of  division  and 
arrangement  from  the  standpoint  of  depreciation  is  too 
often  overlooked,  especially  by  the  companies.  Even 
if  the  intention  of  the  appraiser  is  to  make  no  deduction 
from  cost  of  reproduction  for  accrued  depreciation,  no 
one  disclaims  the  need  of  an  annual  depreciation  reserve 
and  such  reserve  can  be  most  fairly  and  accurately  cal- 
culated, item  by  item,  from  a  properly  arranged  in- 
ventory. 

DETAIL  REQUIRED 

There  is  great  lack  of  uniformity  as  to  both  the  ex- 
tent and  the  nature  of  detailing  inventories.  Hardly 
any  two  appraisals  by  different  parties  agree  in  this 
regard.  Comparisons  other  than  by  totals,  are  there- 
fore very  difficult  and  often  practically  impossible. 
The  amount  of  detail  desired  is  a  perplexing  problem. 
As  a  general  proposition  the  greater  the  detail  the 
greater  the  accuracy.  This  is  not  true  ad  infinitum, 
however,  and,  on  the  other  hand,  it  is  true  that  the 
cost  of  the  appraisal  will  increase  with  the  detail  in- 
volved. The  required  detail  depends  upon  the  nature 
of  the  inquiry  and  the  specific  use  of  the  inventory  in 
connection  therewith.  When  prepared  as  "cost  of 
reproduction"  for  a  court  case  involving  the  question 
of  confiscation  of  property,  much  detail  seems  to  be 
demanded,  and  often,  in  such  cases,  the  extra  cost  of 
proper  and  thorough  detail  in  preparation  and  presen- 
tation of  priced  inventory  will  be  fully  offset  by  saving 
in  the  cost  of  litigation. 

Without  doubt,  considerable  detail  can  be  eliminated 
when  the  inventory  is  made  jointly  by  the  two  parties 
at  issue. 


176 


THE      UTILITIES      MAGAZINE 


No  definite  standardization  can  be  expected,  but  it 
would  be  highly  desirable  for  all  concerned  if  some 
central  organization,  interested  in  such  matters,  should 
discuss  the  subject  and  suggest  certain  alternate  stand- 
ards for  various  purposes  and  for  various  classes  of 
property. 

Aside  from  the  matter  of  desired  detail  in  the  actual 
work  of  compiling  the  appraisal,  there  arises  the  im- 
portant question  of  detail  to  be  made  public  or  embodied 
in  the  report  as  submitted,  and  the  further  detail  to 
be  open  for  examination  and  checking  in  the  case  of 
a  controversy.  How  much  should  actually  be  made 
public  or  submitted  in  the  actual  report  depends  largely 
upon  the  nature  and  circumstances  of  the  case.  Gen- 
erally, considerable  detail  with  the  final  report  is 
highly  desirable.  In  nearly  all  cases,  practically  all 
of  the  detail,  that  is,  all  quantity  detail  and  all  detail 
unit  prices  should  at  least  be  filed  as  supplementary 
evidence  ready  for  use  when  needed.  The  all  too  fre- 
quent practice  of  submitting  only  results  or  various 
totals  with  the  detail  submerged  or  retained  as  private 
property  of  the  appraisers,  should  be  heartily  dis- 
couraged. 

As  a  general  proposition,  it  may  be  said  that  a  priced 
inventory,  in  order  to  measure  up  to  its  full  possibilities 
as  to  various  usages,  creates  a  proper  incentive  to  main- 
tenance and  renders  maintenance  practicable,  and,  in 
order  that  it  may  be  received  with  favor  by  both  sides 
to  the  controversy,  should  be  in  such  detail  and  with 
such  explanation  that  all  phases  of  it  may  be  entirely 
clear  to  qualified  outside  parties,  every  item  of  prop- 
erty sufiiciently  identified  so  that  it  may  be  promptly 
located  in  the  field  and  checked,  all  important  char- 
acteristics affecting  cost  set  forth  and  the  items  to 
which  unit  costs  are  applied  sufficiently  subdivided  so 
that  any  unit  cost  may  be  checked  without  laborious 
effort,  or  much  liability  of  basing  such  checking  upon 
wrong  premises.  In  other  words,  inventories  should 
be  based  upon  the  idea  of  permanence  and  general 
usefulness,  not  merely  made  for  the  purpose  of  estab- 
lishing an  opinion  of  value  or  cost  on  the  part  of  the 
appraiser. 

FORMS 

In  the  actual  making  of  an  appraisal,  the  use  of 
proper  detailed  printed  forms  is  a  matter  of  the  utmost 
importance.  Forms  should  be  such  as  to  indicate 
clearly  the  desired  data  and  automatically  enforce 
their  logical  entry  and  arrangement  with  an  absolute 
minimum  of  writing  on  the  part  of  the  field  engineers, 
and  a  minimum  of  editing  and  transfer  in  the  office. 
Good  field  engineers  are  seldom  good  writers,  especially 
under  the  unfavorable  conditions  of  field  work,  and 
the  time  spent  in  the  office  in  editing,  rearranging, 
compiling  and  summarizing  field  data  has  usually  been 


a  far  too  large  percentage  of  the  total  cost,  and,  besides, 
each  transfer  or  alteration  invites  error.  Much  study 
devoted  to  a  systematized  set  of  combination  forms 
will  be  well  repaid.  The  printing  is  cheap  in  compari- 
son with  the  skilled  labor  saved.  So  far  there  is  prac- 
tically no  uniform  method  or  standardization  in  this 
regard. 

CONCEPTUAL  PROCESS  AND  CONDITIONS 

Any  public  utility  inventory,  both  as  to  items  and 
costs,  must  depend  largely  upon  the  conceptual  process 
upon  which  it  is  based.  This  requires  a  determination 
on  the  part  of  the  appraiser  of  such  moot  principles  as, 
piecemeal  construction  over  a  long  period  of  time 
versus  wholesale  construction  as  a  continuous  process 
throughout  a  comparatively  short  period;  past  versus 
present  topographical  conditions,  including  the  hotly 
contested  question  of  exclusion  or  inclusion  of  paving 
not  paid  for  by  the  company;  construction  by  the 
company  itself  versus  construction  by  contractor,  etc. 

Whatever  the  opinion  of  the  appraiser  in  these  mat- 
ters, a  definite,  logical  and  humanly  practicable  process 
must  be  conceived,  carried  through  consistently  and 
fully  explained  in  the  report. 

COSTS 

Lack  of  uniformity  is  especially  noticeable  in  the 
methods  employed  in  deriving,  segregating  and  apply- 
ing costs  and  the  confusion  is  aggravated  by  the  fact 
that  seldom,  indeed,  do  inventories  or  valuation  reports 
contain  any  specific  statements  as  to  the  methods  upon 
which  the  costs  are  based.  As  a  result,  it  is  extremely 
difficult  and  often  dangerous  to  attempt  to  make  any 
direct  comparisons  of  either  so-called  unit  costs  or  over- 
head charges  by  different  appraisers  without  full  con- 
sideration of  many  facts  not  embodied  in  the  reports. 

The  proper  costs  to  be  applied  to  the  inventory, 
depend,  among  other  considerations,  upon  the  con- 
ceptual process  of  construction  and  the  assumption  as 
to  certain  fundamental  principles  such  as: 

1.  Actual  costs. 

2.  Reproduction  costs. 

3.  Piecemeal  construction. 

4.  Wholesale  construction. 

5.  Time  of  construction  period  assumed. 

6.  Actual  prices  of  materials,  apparatus  and  labor 
as  of  the  date  of  the  valuation,  regardless  of  whether 
any  or  all  of  such  prices  may  be  high  or  low  with  respect 
to  normal. 

7.  Normal  prices  as  of  the  date  of  the  valuation, 
determined  by  averaging  fluctuating  prices  of  a  certain 
period  of  the  past  or  by  deriving  "trend"  therefrom. 

8.  Construction  assumed  to  be  done  by  the  operating 
utility  company  itself. 


MAKING  AND  MAINTENANCE  OF  INVENTORIES 


177 


9.  Construction  assumed  to  be  done  by  a  combined 
engineering-contracting  organization. 

10.  Construction  assumed  to  be  done  by  various 
specialized  contractors  under  the  direction  of  designing 
engineers  or  the  utihty  company's  staflF. 

The  appHcation  of  these  conflicting  principles  will 
depend  largely  upon  the  purpose  of  the  valuation  and 
the  application  of  the  inventory  in  the  process  of  deriv- 
ing value,  but,  even  under  similar  circumstances,  con- 
siderable difference  of  opinion  exists  among  appraisers. 
In  general,  it  would  seem  most  logical  that  where  cost 
of  reproduction,  in  its  strict  sense,  is  being  determined 
as  an  element  of  value  in  contra-distinction  to  that 
other  principal  element,  "actual  cost,"  a  reasonable, 
comparatively  short  period  of  wholesale  continuous 
construction  under  present  topographical  conditions 
should  be  assumed,  the  work  should  be  considered  as 
largely  done  under  contract,  and  the  costs  should  be 
based  on  normal  prices  as  of  the  date  of  the  valuation. 

(The  fact  that  certain  elements  of  cost  of  reproduction 
so  derived  may  not  constitute  elements  of  the  final 
fair  value  or  fair  amount  for  the  purpose  in  hand  does 
not  mitigate  against  their  being  true  elements  of  cost 
of  reproduction.  Paving,  for  instance,  not  paid  for 
by  the  company  can  hardly  be  considered  a  part  of 
fair  value  or  amount  upon  which  to  base  rates,  but  such 
paving  is,  nevertheless,  a  necessary  element  of  cost  of 
reproduction  in  its  strict  sense.  Its  exclusion  is  a  mat- 
ter involved  in  the  final  judicial  process  of  finding  fair 
value.  The  appraiser  in  finding  cost  of  reproduction 
should,  therefore,  include  such  paving,  but  as  a  sepa- 
rate item,  with  attention  called  specifically  to  it  (and 
to  the  proportion  of  overhead  charges  applying  to  it) 
so  that  it  may  not  be  overlooked,  but  may  readily  be 
eliminated  in  the  final  determination  of  fair  value  or 
fair  amount.) 

Cost  analysis  must  harmonize  thoroughly  with  the 
detailing  and  grouping  of  inventory  items.  Too  often 
this  basic  principle  is  lost  sight  of.  Unit  costs  should, 
in  general,  not  be  built  up  but  should  be  compiled  and 
checked  where  possible  in  total,  that  is,  from  corre- 
sponding actual  cost  records,  and  then  analyzed  syn- 
thetically, or  resolved  into  component  elements  of  cost 
varying  with  different  applications. 

Similar  elements  of  cost  vary  throughout  wide  ranges, 
depending  upon  location,  character  of  work,  and  sur- 
rounding conditions.  First  costs  of  materials  and 
freight  will  vary  with  the  locality;  hauling  charges  will 
vary  greatly  with  the  inventoried  locations;  labor  rates 
will  vary  with  the  locality;  and  the  amounts  of  labor 
involved  will  vary  widely  even  at  the  same  inventoried 
location.  But  if  the  estimated  total  costs  applying  to 
important  individual  inventory  items  are  derived  from 
or  checked  with  actual  costs  under  as  many  varied  con- 

12 


ditions  as  possible,  and,  if  then,  each  element  of  such 
costs  is  carefully  analyzed  and  adapted  to  the  varying 
conditions  encountered  in  the  inventory,  the  applica- 
tion of  varied  costs  to  the  inventory  should  be  com- 
paratively simple  and  accurate. 

On  the  other  hand,  since  so  many  varying  factors 
enter  into  them  the  difficulty  of  comparing  unit  prices 
of  different  appraisals  should  be  apparent  even  when 
the  appraisers  have  followed  similar  methods  of  item- 
izing. But  the  methods  of  itemizing  also  differ  con- 
siderably. For  instance,  in  some  inventories  the  item 
written  as  "concrete"  or  "concrete  work"  includes  the 
formwork,  in  others  the  formwork  is  excluded  and  set 
forth  elsewhere  in  the  inventory.  Reinforcing  is  some- 
times included  and  sometimes  treated  independently. 
Likewise,  the  contractor's  indirect  cost  may  be  in- 
cluded in  the  unit  cost  in  one  inventory,  and  set  forth 
elsewhere  in  another.  This  is  true  also  of  contractor's 
profits,  and,  in  whole  or  in  part,  as  to  the  overhead 
charges  of  the  owners.  Accident  insurance,  for  illus- 
tration (quite  an  important  element  of  cost),  may  be 
applied  directly  to  each  labor  element  of  the  unit  costs 
at  the  specific  rate  obtaining  in  the  case,  or  may  be 
treated  as  one  of  the  contractor's  indirect  costs,  and, 
as  such,  excluded  from  the  unit  costs  and  applied  to 
the  total  of  a  group  of  units,  or  may  be,  and  often  is. 
treated  strictly  as  an  overhead  charge. 

There  is  a  rather  common  cause  of  unit  price  varia- 
tion which  may  be  referred  to.  Certain  elements  of 
costs  applying  more  or  less  generally  throughout  a 
valuation  are  frequently  derived  and  set  forth  as  aver- 
age percentages  and  applied  at  uniform  percentage 
rates  to  the  individual  unit  costs.  Obviously,  since 
each  such  percentage  represents  a  general  average,  it 
is  much  higher  than  the  actual  cost  in  some  cases  and 
correspondingly  low  in  others.  In  other  appraisals 
these  same  elements  of  costs  are  directly  derived  for, 
and  specifically  applied  to,  each  unit  price.  The  result 
is  that,  while  the  appraisals  might  agree  in  total,  many 
of  the  unit  prices  will  differ  through  wide  limits  from 
this  cause  alone. 

OVERHEAD  CHARGES 

There  has  been  much  controversy  and  discussion 
regarding  overhead  charges  partially  because  of  exor- 
bitant amounts  or  percentages  set  forth  in  certain  ap- 
praisals and  claimed  by  a  few  companies,  and  partially 
because  of  lack  of  uniformity  in  appraisal  methods. 
Overhead  charges  of  one  appraisal  can  no  more  be 
compared  with  those  of  another  than  can  the  unit  costs, 
without  full  knowledge  of  the  entire  valuation  bases 
and  methods  in  the  two  cases,  which  knowledge  is  usu- 
ally lacking.  This  lack  of  uniformity  as  to  those  costs 
frequently  set  forth  as  "overhead  charges,"  applies  tO; 


178 


THE      UTILITIES      MAGAZINE 


1.  Nature  of  the  costs. 

2.  Amounts  or  percentages  of  such  costs. 

3.  Application  of  such  costs  in  the  inventory. 

1.  Disagreement  and  controversy  as  to  the  inclusion 
or  exclusion  from  the  valuation  of  overhead  cost  items 
of  certain  natures  are  to  be  expected  at  this  stage  of 
unsettled  condition  of  the  subject  of  valuation  in  gen- 
eral, and  will  not  be  discussed  here. 

2.  The  amounts  or  percentages  of  such  costs  as  are 
properly  to  be  included  will  naturally  vary  somewhat, 
and  sometimes  unwisely,  according  to  the  attitude  or 
judgment  of  the  appraiser,  and  to  that  extent  contro- 
versy is  to  be  expected.  But  aside  from  this,  the 
amounts  or  percentages  will  logically  and  properly  vary 
with  the  conceptual  process,  period  and  continuity  of 
construction  assumed,  upon  which  the  appraisal  as  a 
whole  is  based.  Interest  and  taxes  during  construction, 
engineering,  organization  for  construction,  etc.,  will 
largely  depend  upon  these  factors.  One  basic  assump- 
tion may  lead  to  comparatively  low  unit  costs  and 
comparatively  high  overhead  charges,  and  vice  versa. 
Again,  the  amounts  or  percentages  added  for  such 
items  as  "omissions  from  inventory,"  should  naturally 
depend  directly  upon  the  care  and  detail  with  which 
the  individual  divisions  of  the  inventory  have  been 
compiled.  If,  for  economical  reasons  or  lack  of  time, 
any  part  of  the  inventory  has  been  so  taken  as  to  lead 
to  omissions,  a  reasonable  percentage  must  be  added. 

3.  A  frequent  cause  of  dissimilarity  in  the  overhead 
charges,  actually  shown  as  such,  is  due  to  the  fact  that 
there  is  no  general  uniformity  as  to  where  the  line  is  to 
be  drawn  between  unit  costs  or  group  costs  on  the  one 
hand,  and  overhead  charges  on  the  other.  Contractor's 
profit,  for  instance,  when  included,  sometimes  appears 
in  the  unit  costs,  sometimes  is  added  to  the  various 
subtotals  of  unit  costs,  and  sometimes  is  applied  at  the 
end  strictly  as  an  overhead  charge.  This  is  equally 
true  for  such  items  as  insurance,  contingencies,  etc. 

For  the  sake  of  uniformity,  it  would  seem  wise,  where 
construction  is  assumed  to  be  done  under  contract,  that 
all  charges  (costs  and  profits)  of  the  contractor  or  con- 
tractors should  be  included  in  the  basic  costs  of  the 
inventory,  and  that  all  other  costs  which  would  logi- 
cally and  properly  be  borne  by  the  owner  in  connection 
with  construction,  be  set  forth  as  overhead  charges. 

MAINTENANCE  OF  INVENTORY 

This  subject  has  been  touched  upon  in  several  in- 
stances in  this  paper.    The  various  usages  hereinbe- 


fore referred  to  are  certainly  of  sufficient  importance  to 
render  the  maintenance  of  inventories  highly  desirable 
to  both  the  public  and  the  corporations.  Valuations  so 
far  have  been  mostly  mere  "flashes  in  the  pan" — most 
expensive  procedures  for  specific  purposes,  and  then 
discarded  and  the  process  repeated  when  a  need  next 
arises.  If  inventories  are  made  on  the  cost  of  repro- 
duction basis,  properly  detailed,  with  not  too  much 
transposition  and  summarizing  of  items,  with  all  phys- 
ical property  listed  and  segregated,  and  with  normal 
prices  applied,  the  inventories  can  be  maintained  to 
advantage  and  such  maintenance  should  be  strongly 
advocated. 

Inventories  should  be  maintained  by  the  operating 
companies.  The  public  will  pay  the  cost  in  any  case 
as  the  inventory  maintenance  will  become  an  operating 
cost.  A  permanent  valuation  staff  should  be  organ- 
ized within  the  company  for  the  purpose,  utilizing  the 
managerial,  auditing,  engineering,  purchasing  and  op- 
erating departments,  but  all  under  outside  direction 
and  supervision.  The  maintenance  of  the  inventory 
can  be  made  a  much  more  simple  task  than  is  generally 
assumed.  A  large  proportion  of  the  requisite  data  for 
maintenance  can  be  obtained  almost  automatically  and 
with  moderate  extra  labor,  if  the  printed  forms  used  in 
the  various  departments  with  respect  to  purchasing, 
construction,  renewals,  repairs,  etc.,  are  printed  with 
inventory  maintenance  in  mind.  Requisitions  on  the 
purchasing  department,  purchasing  orders,  manufac- 
turers' and  dealers'  invoices,  construction  requisitions, 
work  orders,  time  slips,  operating  reports,  etc.,  can  all 
be  made  to  convey  in  concise  and  simple  manner  data 
requisite  for  the  purpose.  Inventory  maintenance  in 
this  manner  would  result  in  highly  desirable  standard- 
ization of  purchasing  and  construction  methods  and 
cost  keeping. 

The  internal  staff  alone  cannot,  however,  be  relied 
upon  to  properly  maintain  the  inventory.  As  stated 
above,  the  work  must  be  under  outside  direction  and 
supervision :  first,  direction  by  an  independent  special- 
ist in  valuation  engineering,  devoting  as  much  time  to 
the  work  as  may  be  required,  and,  second,  under  the 
supervision  and  periodical  checking  of  a  qualified  rep- 
resentative of  the  public.  No  stafiF  wholly  within  the 
company,  and  with  inventory  maintenance  merely  a 
side  issue  and  added  burden  of  each  member,  will  prop- 
erly maintain  the  inventory  and  no  such  inventory  will 
fulfill  the  possibilities  and  justify  its  cost  unless  main- 
tained upon  some  basis  satisfactory  to  the  public. 


MAKING    AND    MAINTENANCE    OF    INVENTORIES 


179 


DISCUSSION 


I  propose  to  talk  only  on  one  phase  of  the  subject  of  the 
making  of  an  inventory.  A  great  deal  has  been  said  here 
this  morning  about  the  actual  cost  and  reproduction  cost  in 
valuation,  but  the  most  important  in  gaining  results,  is  the 
making  of  an  inventory  of  the  pubHc  utility  to  be  valued, 
and  a  great  deal  more  care  should  be  exercised  in  making  it 
than  in  its  maintenance.  The  paper  that  has  just  been  read 
gives  you  a  general  idea  of  the  subject  and  uses  the  term 
"price  valuation."  An  inventory  is  the  same,  whether  it  is 
to  be  used  for  sale,  reproduction,  rate  making  or  bond  issue. 
It  is  the  foundation  upon  which  to  base  all  valuations,  and 
should  be  taken  and  made  with  the  same  care  of  selection 
as  to  basic  units,  whatever  end  is  to  be  attained.  In  comput- 
ing the  units,  whatever  utilities  you  are  making  the  inven- 
tory of,  is  a  question  that  is  different  in  the  different  utiUties. 
From  the  engineering  standpoint,  it  would  be  best  to  take 
all  the  units  going  into  the  structure,  of  every  character,  and 
placing  them  in  tabulated  form,  in  such  a  way  as,  when  it 
comes  to  the  appraisal,  you  will  be  able  to  determine  the 
physical  depreciation,  and  base  your  unit  prices  as  to  the 
physical  depreciation  of  the  different  items  or  basic  units; 
that  you  should  have  segregated  the  inventory  classifying 
and  grouping  them  in  such  a  manner  so  as  to  readily  deter- 


Bt  James  W.  Phillips 
Grade  Crossing  Division,  Bureau  of  Surveys,  Philadelphia 

mine  the  unit  prices  of  the  valuation,  whatever  object  that 
valuation  may  tend  or  be  used  for;  and  also  to  group  it  so 
that  both  the  physical  and  functional  depreciation  can  be 
readily  taken  care  of,  if  any  occurs. 

The  corps,  or  staff  assigned  to  take  the  inventory,  should 
be  men  conversant  in  every  detail  of  construction  and  class- 
ification of  materials,  so  that  they  can  be  properly  and 
rightly  classified  into  units  and  tabulated  for  the  appraiser. 
If  it  happens  to  be  the  appraiser  of  a  board  of  engineers, 
different  from  those  who  take  the  tabulation  and  inventory  in 
the  field,  it  should  be  classified  and  grouped  into  units,  that 
it  would  come  to  appraisers  so  that  their  labors  would  be 
facilitated  in  the  proper  grouping  of  the  different  materials 
and  parts  of  the  utilities  company. 

After  making  the  inventory,  the  maintenance — ^not  taking 
in  the  accounting,  only  physical  imits — is  very  easily 
maintained.  The  inventory  in  my  mind  is  nothing  more 
than  the  stock-taking  of  the  old  term  "stock-taking";  but 
it  has  become  a  very  important  factor  with  the  utilities  com- 
panies, that  it  has  considerable  importance  in  the  valuation 
of  the  dififerent  uses  which  they  desire  to  make  of  it,  as  in  the 
rate  making,  bond  issue,  reproduction  or  for  sale. 


SOME  ESSENTIALS  OF  APPRAISAL  WORK 

By  F.  W.  Ballahd 
Commissioner  and  Chief  Engineer,  Division  of  Light  and  Heat,  Cleveland,  Ohio 


Mr.  Pillsbury  very  correctly  makes  the  statement  that 
the  cost  of  reproduction  is  of  great  importance  in  making 
inventories  and  valuing  public  utility  properties.  In  fact, 
cost  of  reproduction  is  the  basis  upon  which  financial  valua- 
tion must  be  made.  In  very  few  cases  is  it  possible  to  deter- 
mine what  the  actual  original  cost  was  and  even  when  this 
is  available  from  records,  it  would  be  of  far  less  value  than 
to  know  the  cost  of  reproduction. 

Construction  work  costs  more  now  than  it  did  a  few  years 
ago  and  is  certainly  very  much  higher  in  cost  than  it  was  a 
great  number  of  years  ago,  and  this  is  true  notwithstanding 
the  fact  that  improvements  and  efficiencies  in  many  ways 
tend  toward  reduced  cost.  Yet,  on  the  whole,  construction 
work  of  almost  every  character  is  more  expensive  now  than 
it  has  been  in  years  past.  This  is  largely  for  the  reason  of 
higher  wages,  higher  priced  material,  and,  that  generally 
better  grades  of  material  are  being  used.  Notwithstanding 
this,  however,  reproduction  costs  are  generally  found  to  be 
less  than  original  costs.  The  particular  reason  for  this  is 
that  in  almost  every  case  it  is  found  that  public  utility  prop- 
erties and  also  industrial  properties  have  been  built  on  the 
piecemeal  plan.     This,  of  course,  has  been  necessary  because 


capacity  requirements  are  very  seldom  as  large  at  the  incep- 
tion of  the  business  as  they  grow  to  be  later  on.  Electric 
light  plants,  water  works  plants,  electric  railway  plants,  and, 
in  fact,  all  utiUty  properties  are  generally  found  to  grow  in 
their  demands  for  capacity  and  in  the  extensions  of  their 
service  lines.  Manufacturing  plants  are  generally  subject 
to  the  same  conditions,  starting  as  small  concerns  with  small 
plants,  and  as  the  demands  for  greater  capacity  come  on, 
the  requirements  are  met  by  small  additions,  so  that  the 
ultimate  property  is  found  to  consist  of  a  small  nucleus  to 
which  has  been  added,  periodically,  additions  and  extensions 
that  increase  the  investment  cost  far  beyond  what  it  would 
have  been  could  the  property  have  been  correctly  designed. 
This  generally  results  in  the  cost  of  operation,  due  to  the  in- 
efiiciency  of  the  final  arrangement,  being  much  greater  than 
it  should  be.  Increased  efficiency  and  lower  production  cost 
would  in  many  cases  warrant  scrapping  the  old  properties 
and  erecting  new  and  better  designed  plants. 

In  starting  an  inventory  for  making  an  appraisal  of  repro- 
duction costs  of  any  property,  whether  a  public  utility  or  an 
industrial  plant,  one  does  not  need  to  bear  in  mind  the  pur- 
pose for  which  the  valuation  is  to  be  made.     The  intention 


180 


THE      UTILITIES      MAGAZINE 


for  the  moment  is  to  determine  two  things.  What  would  be 
the  cost  of  reproduction  and  what  is  the  present  value  of  the 
plant;  i.e.,  reproduction  cost  less  depreciation?  For  this 
purpose  the  first  thing  to  do  is  to  make  a  complete  and  ac- 
curate inventory  of  the  property  with  all  its  detailed  items 
properly  classified  and,  with  this  object  in  mind,  it  matters 
little  whether  the  appraisal  is  to  be  made  of  a  utility  property 
or  of  an  industrial  plant.  The  principles  governing  the 
method  of  procedure  are  the  same.  The  first  thing  to  do 
is  to  properly  sectionalize  the  work.  If  it  is  a  manufactur- 
ing plant  to  be  appraised,  then  the  sections  generally  consist 
of  the  different  buildings  in  the  property,  designated  by  serial 
numbers.  For  a  utiUty  property,  however,  the  requirements 
are  somewhat  different  and,  while  important  buildings  should 
be  given  section  numbers,  the  property  is  generally  to  a  large 
extent  spread  over  the  entire  area  of  a  city  and  this  area  should 
be  divided  into  sections,  the  boundaries  of  which  are  definitely 
determined  and  given  the  least  chance  of  duplication  or 
omission  of  items.  Under  each  section  number  in  the  in- 
ventory should  appear  lists  of  the  items  arranged  under  the 
various  classifications.  In  the  recapitulation,  the  amounts 
of  these  classifications  should  be  collected  under  the  section 
headings  and  arranged  in  practically  the  same  order  in  which 
they  appear  in  the  main  body  of  the  inventory. 

To  prepare  a  proper  and  correct  inventory,  great  care  must 
be  exercised  in  listing  the  items.  Too  great  an  emphasis 
cannot  be  placed  upon  this  requirement.  The  value  of  the 
appraisal  will  to  a  large  extent  depend  upon  the  accuracy  of 
the  lists.  Listing  and  pricing  of  many  items  should  be  done 
by  the  same  person.  For  instance,  no  one  could  place  a 
price  upon  a  pattern  or  a  special  tool  but  the  person  who  had 
seen  it.  This  is  not  only  true  of  such  extreme  cases  but  is 
more  or  less  true  of  all  kinds  of  construction  work.  The  man 
who  does  the  pricing  should  have  actually  seen  the  thing  upon 
which  he  attempts  to  place  a  value  and,  moreover,  he  should 
be  familiar  with  the  cost  of  doing  such  work  and  really  should 
have  had  experience  in  just  that  particular  kind  of  construc- 
tion. 

Condition  pricing  or  listing  of  depreciation  for  each  item 
is  of  next  importance  and  requires  considerable  experience 
on  the  part  of  the  person  doing  the  work.  The  more  complete 
the  information  regarding  the  life  of  the  particular  materials 
under  consideration  the  more  accurate  and  reliable  will  this 
part  of  the  work  be.  Too  often  condition  pricing  is  mere 
guess-work  based  upon  no  knowledge  or  experience.  All 
the  various  items  of  the  different  kinds  of  material  involved, 
the  different  machines  under  consideration,  must  all  be 
judged  as  to  their  present  value  as  distinguished  from  their 
reproduction  costs — the  life  of  a  cast  iron  pipe  underground 
as  distinguished  from  the  life  of  steel  or  wrought  iron  pipes, 
the  average  life  of  poles  with  treated  and  untreated  butts, 
the  average  life  of  weather  proof  wire,  the  effect  of  climatic 
conditions  in  various  localities  upon  these  materials.  The 
inherent  characteristics  of  various  materials  of  construction 
and  the  effect  upon  the  life  of  the  structure  must  all  be 
taken  into  consideration.  For  instance,  in  buildings  the 
walls  of  which  are  built  of  common  clay  brick  laid  in  lime 


mortar  should  not  be  allowed  a  life  of  more  than  from  30  to 
40  years,  and  if  such  a  building  is  being  appraised  and  it  has 
been  in  existence  for  20  years,  it  should  be  placed  under  a 
present  value  of  only  50  per  cent  of  the  reproduction  cost  and 
so  through  the  various  items  the  life  of  the  particular  material 
under  consideration  with  ordinary  wear  and  tear  must  be 
known.  In  addition,  the  person  doing  this  work  must  be 
able  to  distinguish  between  what  should  be  considered  as 
ordinary  wear  and  tear  and  what  would  be  excessive  depre- 
ciation and  should  make  proper  allowance.  On  the  other 
hand,  the  life  of  machinery  may  be  greatly  prolonged  be- 
yond the  average  by  care  and  skill  in  its  use  and  by  care  in 
its  maintenance.  This,  also,  should  be  given  full  consid- 
eration in  condition  pricing. 

The  inventory  of  a  growing  concern,  however  accurately 
made,  soon  becomes  of  little  value  for  any  purpose  when 
repairs,  additions,  and  extensions  are  being  made  all  the  time 
and  in  all  parts  of  the  property.  New  structures  will  be 
added,  new  machinery  will  be  installed,  extensions  and  addi- 
tions of  all  kinds  will  be  made,  items  that  were  very  greatly 
depreciated  at  the  time  of  the  appraisal  may  be  repaired  and 
put  in  first-class  condition  or  may  be  entirely  renewed,  so 
that  after  a  few  years  the  appraisal  may  become  of  almost 
no  value  for  any  purpose  whatsoever,  unless  proper  records 
have  been  made  of  all  these  repairs  and  additions.  It  is  no 
ordinary  task  to  properly  maintain  a  priced  inventory  so 
as  at  any  time  after  months  or  years  have  elasped  to  have 
it  fuUy  as  reliable  as  when  first  made.  A  few  years  ago  the 
writer  had  charge  of  making  an  appraisal  of  all  the  property 
of  a  large  manufacturing  concern  which  had  various  plants 
located  throughout  the  United  States  and  Canada  with  a 
value  of  about  $10,000,000.  A  complete  inventory  was  made 
of  all  this  property  correctly  priced  with  depreciation  al- 
lowed for  all  items.  The  problem  of  maintaining  this 
appraisal  so  that,  after  a  lapse  of  months  or  years  it  would 
be  as  reliable  as  when  first  made,  was  one  of  the  requirements 
in  connection  with  the  work.  The  plan  followed  out  for  this 
purpose  was  as  follows: 

A  complete  job  order  system  as  an  auxiliary  to  the  mechan- 
ical and  engineering  department  had  been  in  use  for  several 
years.  In  this  job  order  system  all  work  of  any  kind  what- 
soever was  carried  by  jobs  ranging  from  $10  in  value  to  over 
$100,000,  and  this  work  was  all  classified  as  maintenance  or 
new  plant  work.  These  job  orders  for  all  the  various  plants 
generally  numbered  between  3,000  and  4,000  per  year  and, 
in  order  to  use  them  as  an  aid  in  maintaining  the  records  of 
the  appraisal  complete,  it  was  necessary  to  have  a  very 
carefully  worked  out  system  by  which  this  could  be  accom- 
plished. For  this  purpose  every  job  order  when  it  was 
issued,  would  be  given  such  reference  numbers  and  identifi- 
cation marks  as  would  properly  classify  it  under  the  various 
sections  and  classifications  of  the  inventory  in  regard  to  the 
buildings,  machinery,  etc.,  so  that  when  the  work  was  com- 
plete the  cost  of  the  job  was  not  only  charged  into  the  proper 
account,  but  there  was  also  a  record  made  under  the  proper 
classification  columns  as  an  addition  or  appendix  to  the  origi- 


MAKING    AND    MAINTENANCE    OF    INVENTORIES 


181 


nal  appraisal  sheets  that  would  show  the  amount  of  the 
work,  classification  to  which  it  belonged,  the  date  when  the 
job  was  done,  a  short  title  or  description  of  the  work  and  ref- 
erence numbers  to  the  job  order  files,  so  that  these  job  orders 
could  always  be  obtained  from  which  full  details  in  regard  to 
the  work  would  be  available.  Complete  records  on  separate 
sheets  were  maintained  in  regard  to  the  removal  or  scrapping 
of  all  machinery  or  equipment  and,  also,  in  regard  to  the  raz- 
ing of  old  buildings  or  those  which  were  removed  to  provide 


room  for  larger  or  better  new  buildings.  All  of  this  was,  of 
course,  written  off  of  plant  account  and  charged  to  depre- 
ciation and  was  set  up  as  a  decrease  in  valuation  to  be  distin- 
guished from  the  increase  due  to  new  construction.  In  this 
way  a  complete  record  was  kept  so  that  at  any  time  totals 
could  be  taken  off  under  the  proper  classifications  through 
the  whole  range  of  the  original  inventory  which  was  in  this 
way  maintained  complete  in  every  detail  and  absolutely  up 
to  date  every  month  and  every  year. 


CO-OPERATION  IN  MAKING  INVENTORIES 

By  R.  J.  Meigs 

Valuation  Engineer,  Western  Union  Telegraph  Company,  New  York  City 


I  have  read  and  listened  to  Mr.  Pillsbury's  paper  with  a 
great  deal  of  interest,  but,  as  I  read  it  and  tried  to  find  a  place 
where  I  could  take  hold  and  prepare  some  kind  of  construct- 
ive discussion,  I  was  confronted  with  the  condition  that  as 
I  agree  entirely  with  the  things  Mr.  Pillsbury  has  set  down 
so  clearly,  it  is  almost  impossible  for  me  to  add  very  much 
of  a  helpful  nature.  Under  these  circumstances,  I  propose 
to  confine  myself  to  the  inventory  stage  and  emphasize  one 
thing  which  is  mentioned  in  the  paper,  and  which  I  think  is 
one  of  the  most  important  things  to  be  taken  into  considera- 
tion in  connection  with  the  work  of  inventorying  and  ap- 
praising the  property  of  public  utilities.  I  refer  to  the 
necessity  for,  and  the  value  of,  the  very  closest  kind  of  co-op- 
eration between  the  representatives  of  the  utilities  and  the 
representatives  of  the  investigating  body;  referring,  as  I  am 
particularly,  to  investigations  which  are  carried  on  by  the 
various  commissions.  Governor  Eshleman  spoke  in  a  con- 
vincing way  on  this  idea  of  co-operation  last  night. 

If  I  understand  the  purposes  of  The  Utilities  Bureau,  one 
of  the  ends  to  be  attained  is  to  bring  about  an  understanding 
of  the  various  complex  matters  in  connection  with  the  regula- 
tion of  public  utilities,  at  least  so  far  as  such  an  understand- 
ing may  be  reached;  and  though  I  do  not  find  it  so  stated  in 
the  prospectus,  I  believe  you  also  desire  to  bring  together 
the  men  on  the  two  sides  of  the  question  who  must  be  charged 
with  the  responsibility  of  bringing  about  a  proper  relation 
between  the  utilities  and  the  public.  If  the  work  of  making 
an  inventory  and  appraisal  were  absolutely  in  the  hands  of 
the  men  on  each  side  of  the  question,  who  are  in  supervisory 
charge  of  the  work,  or  who  direct  it,  there  would,  in  my  opin- 
ion, be  very  few  cases  which  would  not  be  amicably  settled, 
and,  I  might  say,  fairly  settled,  with  due  regard  to  the  inter- 
ests of  both  sides.  But  it  is  an  unfortunate  fact  that,  no 
matter  how  much  those  of  us  who  are  in  charge  of  the  work 
may  desire  to  get  at  the  facts  and  do  the  right  thing  by  both 
sides,  it  seems  to  be  almost  impossible  to  carry  this  spirit 
down  through  the  organization  to  the  men  who  actually 
make  the  inventory,  but  upon  whose  judgment  we  must 
often  rely  and  by  whose  acts  we  so  often  have  to  stand. 

At  the  risk  of  being  misunderstood,  and  with  all  due  respect 
and  regard  for  the  public-spirited  men  who  serve  on  our 
various  commissions,  I  want  to  bring  out  the  fact  (for  I 


believe  it  is  a  fact)  that,  when  a  commission,  municipality, 
or  any  other  governing  body  undertakes  to  investigate  the 
affairs  of  an  individual,  or  a  corporation,  human  nature  at 
once  steps  in  and  the  average  employee  of  the  investigating 
body  takes  the  attitude  that  he,  backed  by  the  authority  to 
which  he  reports,  must  not  be  disputed.  I  might  say  that 
it  takes  much  more  than  the  average  strength  of  character 
to  overcome  this  feeling,  which  is  more  or  less  present  in  all 
of  us. 

I  think  it  may  be  said,  without  fear  of  contradiction,  that 
no  inventory  and  appraisal  can  be  properly  made  and  fairly 
made  unless  both  sides  get  together  with  the  idea  that  they 
are  going  to  do  a  good  job  and  a  fair  job  for  all  concerned, 
and  it  is,  therefore,  incumbent  upon  us  who  are  in  charge  of 
such  work  to  select  our  subordinates  not  only  for  their  ability 
and  experience  in  the  particular  line  of  work  for  which  we 
employ  them,  but  also  with  a  view  of  their  fair-mindedness, 
and  their  ability  to  see  both  sides  of  the  question  as  clearly 
as  may  be.  In  the  selection  of  a  force  for  inventory  work, 
we  should  have  a  sufficient  number  of  high-grade  supervisors 
who  will  be  always  on  the  alert  to  see  that  the  men  who  are 
actually  doing  the  inventory  work  are  doing  a  fair  and  square 
job.  And,  again,  at  the  risk  of  being  misunderstood,  I  want 
to  say  I  believe  that  this  responsibility  rests  with  the  men 
who  are  in  charge  of  the  work  for  the  investigating  body  to 
a  greater  degree  than  it  does  with  the  men  who  are  repre- 
senting the  corporations.  I  don't  mean  by  this  that  the 
corporation  man  is  always  unbiased  and  the  representative 
of  the  investigating  body  is  always  biased.  It  might  very 
well  be  said  that  the  conditions  are  more  in  favor  of  the 
opposite  view  for  the  reason  that  the  representative  of  the 
investigating  body  is  not  financially  interested  in  the  cor- 
poration nor  is  he  interested  in  his  own  side  of  the  case, 
except  in  so  far  as  holding  his  job  is  concerned,  and  his  job 
is  usually  a  temporary  one.  But  I  get  right  back  again  to 
the  fundamental  fact,  that  we  always  have  human  nature 
to  deal  with,  and  the  tendency  of  the  man  with  the  whip- 
hand  is  to  use  the  whip.  As  I  said  before,  he  must  have  a 
strong  character  to  know  when  and  when  not  to  use  it. 

I  believe  that  most  public  utilities  are  anxious  to  do  all 
they  can  to  assist  in  any  investigations,  inventories  and 
appraisals,  which  are  being  or  will  be  made  by  governing 


182 


THE      UTILITIES      MAGAZINE 


authority.  I  am  sure  that  I  can  make  the  statement,  so  far 
as  my  own  company  is  concerned,  without  any  reservation. 
All  rules  have  exceptions,  but  I  believe  the  exceptions  in 
this  respect  will  be  very  few.  When  I  say  that  I  believe  the 
corporations  are  anxious  to  do  all  they  can  to  help,  I  do  not 
mean  to  say  that  they  would,  as  a  rule,  go  to  the  expense  to 
do  the  work  in  the  detail  usually  required  by  the  commissions 
if  they  were  not  compelled  to  do  it,  because,  while  in  many 
cases  the  corporations  benefit  to  a  certain  extent  by  the 
information  gathered  and  tabulated,  they  nevertheless,  if 
they  were  left  to  their  own  devices,  could  gather  and  tabulate 
the  information  which  they  themselves  need  at  very  much 
less  expense  than  they  are  put  to  by  reason  of  co-operating 
with  the  various  investigating  bodies.  But,  after  all,  as 
Mr.  Pillsbury  says  in  his  paper,  the  public  will  pay  the  cost 
in  any  case;  so  why  should  not  the  corporations  do  what 
they  can  and  what  they  should  to  insure  a  proper  result? 

There  are,  of  course,  many  complex  questions  in  con- 
nection with  the  inventory  of  a  large,  public  utility  and  its 
subsequent  appraisal,  which  must  be  settled  in  some  way 
and  for  which  no  definite  rules  have  yet  been  laid  down. 
Many  of  these  questions  are  mentioned  in  Mr.  Pillsbury's 
paper.  There  are  so  many  different  factors  to  be  considered 
in  connection  with  an  inventory  and  appraisal,  and  so  many 
different  ways  in  which  the  inventory  and  appraisal  may  be 
used,  that  it  would  seem  almost  an  impossibility,  for  instance, 
to  lay  down  definite  rules  for  the  determination  of  such  items 
as  the  intangibles.  But  this  much  can  be  said:  if  the  parties 
concerned  approach  the  subject  with  open  minds  and  in  a 
spirit  of  fair  play,  decisions  can  and  will  be  arrived  at. 

As  Mr.  Pillsbury  says  in  his  paper,  the  purpose  to  which 
an  inventory  and  appraisal  is  to  be  put,  will  very  largely 
determine  the  way  in  which  the  work  must  be  done,  and  I 
want  to  emphasize  the  fact  that  the  job  would  in  most  cases 
be  very  much  simplified,  the  questions  involved  would  be 
very  much  more  easily  settled,  and  the  speed  at  which  the 
work  could  be  accomplished  would  be  increased,  if  whenever 
legislative  bodies  order  an  appraisal  they  would  indicate  the 
piu-pose  to  which  it  is  to  be  put.  The  Interstate  Commerce 
Act,  for  instance,  under  which  the  inventory  and  appraisal 
of  the  property  of  all  common  carriers  engaged  in  interstate 
commerce  is  now  going  on,  is  absolutely  silent  as  to  the 


purpose  of  the  act,  the  Interstate  Commerce  Commission 
simply  being  instructed  to  "investigate,  ascertain  and  report 
the  value  of  all  the  property  owned  or  used  by  every  common 
carrier  subject  to  the  provisions  of  the  act."  Because  of 
this  uncertainty  as  to  the  use  to  which  an  inventory  and 
appraisal  may  be  put,  the  only  safe  course  to  pursue  is  to 
inventory  everything  and  to  record  it  in  such  a  way  that  the 
various  items  may  be  grouped  as  desired. 

The  inventory  is,  in  a  way,  the  simplest  part  of  the  work 
of  the  appraisal,  but  unless  it  is  properly  done,  the  appraisal 
will  of  necessity  be  valueless  and  it  is,  therefore,  very  impor- 
tant that  the  work  should  be  well  considered  and  planned  in 
advance,  and  that  all  those  who  will  participate  should  be 
thoroughly  instructed  as  to  their  duties  and  should  above  all 
be  men  who  have  had  experience  with  the  property  to  be 
inventoried.  The  field  parties  should  be  under  constant  and 
direct  supervision  of  competent  and  practical  men  of  sufficient 
engineering  ability  and  mental  capacity  to  enable  them  to 
smooth  out  such  difficulties  as  will  inevitably  be  encountered 
in  the  field  work. 

It  is  also  very  important  that  the  inventory  of  a  large 
property,  extending  over  a  wide  territory,  should  be  carried 
on  under  the  same  general  plans  and  that  so  far  as  may  be, 
the  details  of  the  work  will  be  the  same.  By  this  I  mean 
that  the  work  of  the  investigating  authority  should  be  under 
the  general  supervision  of  one  competent  head  who  will  see 
to  it  that  the  methods  adopted  are  the  same  for  all  parts  of 
the  plant,  that  the  same  instructions  are  issued  and  explained 
in  the  same  way  to  all.  This  also  holds  true  of  the  company 
organization,  where  the  inventory  is  a  joint  one,  or  where 
the  company  participates  in  the  work.  Among  the  greatest 
difl3culties  encountered  in  a  large  job  of  this  kind  are:  lack 
of  uniform  methods,  of  uniform  understanding  of  instructions, 
of  a  uniform  spirit  of  co-operation,  and  the  failure  of  some 
small,  but  none  the  less  important  elements  of  the  organiza- 
tion, to  look  on  the  work  in  a  broad-minded  way,  and  attempt 
to  reach  conclusions  which  will  be  fair  for  all  concerned. 

If  we  can  get  the  right  men,  give  them  plain  and  sensible 
instructions  and  intelligent  supervision,  then  all  of  us  ap- 
proach the  work  with  a  spirit  of  co-operation  rather  than 
suspicion,  I  think  we  will  find  most  of  ovu*  troubles  have 
disappeared. 


VALUATION   BY   APPROXIMATION 


183 


VALUATION  BY  APPROXIMATION 

By  John  G.  Morse 

Appraiser,  Associated  Factory  Mutual  Fire  Insurance  Companies,  Boston,  Mass. 


THE  Factory  Mutual  Fire  Insurance  Companies, 
in  the  effort  to  conduct  their  business  on 
mutual  principles,  require  that  each  member 
shall  carry  insurance  amounting  to  at  least  90  per  cent 
of  the  value  of  the  property  insured.  As  a  means  of 
knowing  what  the  values  actually  are,  they  have  for 
years  maintained  in  connection  with  their  inspection 
work,  a  department  devoted  to  making  valuations. 

This  valuation  work  has  been 
developed  with  the  end  con- 
stantly in  view  of  saving  time 
and  unnecessary  expense  by 
omitting  detail  and  obtaining, 
as  far  as  possible,  accurate  fac- 
tors for  simplifying  and  shorten- 
ing the  work.  These  factors  are 
based  on  a  vast  number  of  act- 
ual figures.  That  the  assured 
so  often  use  the  valuations  for 
cost  systems  and  other  book- 
keeping purposes,  as  well  as  for 
fixing  the  amount  of  insurance, 
is  evidence  of  the  satisfactory 
accuracy  of  the  results.  We 
feel  confident,  therefore,  that 
dependable  valuations  can  be 
made  by  our  methods  and  I 
have  been  asked  to  explain  the 
system  and  will  do  so,  en- 
deavoring at  the  same  time  to 
prove  the  uselessness  of  more 
extended  detail. 


PART  X 

MAKING  INVENTORIES  WORTH 
WHAT  THEY  COST 


It  is  a  misnomer  to  call  the  method  herein  des- 
cribed by  Mr.  Morse  as  Valuation  by  Approxima- 
tion. Certain  it  is  that  the  greater  portion  of  the 
so-called  valuations  put  before  Public  Service  Com- 
missions by  our  serving  corporations  do  not  approx- 
imate real  values  in  any  such  direct  sense  as  the 
methods  used  by  the  Associated  Factory  Mutual  Fire 
Insurance  Companies  and  other  industrials.  Ap- 
praisals made  on  the  common  sense  lines  indicated 
here  are  not  mere  estimates  as  have  been  the  greater 
number  of  valuations  worked  up  by  utility  corpora- 
tions. The  amount  of  money  now  being  thus  use- 
lessly sunk  in  valuation  procedure  is  a  matter  of 
real  concern  to  the  constmiers  who  finally  pay  for 
them.  If  these  useless  expenses  were  not  so  easily 
shifted  to  the  consiuner  the  utility  companies  would 
soon  be  using  as  much  care  and  as  large  portion  of 
facts  in  their  appraisals  as  these  industrial  com- 
panies are  using. 


not  remain  accurate  for  any  length  of  time.  Then, 
when  the  above  figures  have  all  been  compiled,  the 
amount  of  depreciation  on  both  buildings  and  machin- 
ery must  be  estimated,  or  largely  guessed  at,  before 
the  actual  present  value  is  found. 

Some  engineer  once  made  a  statement  to  the  effect 
that  in  computing  the  circumference  of  a  circle,  it  was 
useless  to  carry  the  result  into  decimals   where  the 

diameter  had  been  obtained  by 
pacing.  With  similar  logic,  we 
claim  that  it  is  useless  to  waste 
time  on  minor  detail  in  making 
an  appraisal,  if  a  goodly  pro- 
portion of  the  work  must  of 
necessity  be  based  on  estimate. 
Moreover,  we  have  proved  again 
and  again  that  the  great  law 
of  averages  counterbalances  all 
minor  errors. 


AN  ACCURATE   METHOD 
OF  APPROXIMATION 


THE   MOST  ELABORATE   APPRAISALS   REST 
LARGELY  ON  ESTIMATE 

It  should  be  borne  in  mind  that  no  appraisal  can  be 
made,  regardless  of  the  time  and  pains  taken,  without 
incorporating  many  figures  that  are  based  simply  on 
estimate.  Let  a  building  be  measured  so  carefully  that 
the  exact  amount  of  materials  is  known  and  let  it  be 
made  positive  that  the  exact  cost  of  each  kind  of 
material  is  known;  the  amount  to  allow  for  waste  must 
be  estimated  and  the  amount  for  labor  and  all  contin- 
gent expenses  must  be  estimated.  Let  the  inventory  of 
machinery  be  made  to  the  last  trifling  detail,  the  exact 
value  of  only  standard  machines  can  be  obtained. 
The  value  of  each  special  machine  must  be  estimated 
and  the  cost  for  erection  of  every  machine  must  be 
estimated.     As  market  values  change,  the  results  can- 


The  method,  as  developed  in 
our  department,  first  divides  a 
manufacturing  plant  into  build- 
ings and  machinery.  To  sim- 
plify matters,  buildings  are  con- 
sidered as  empty  structures.  All 
elevators,  piping,  wiring  and, 
indeed,  anything  that  can  be 
removed  without  altering  the 
building,  are  classed  under  ma- 
chinery. Machinery,  in  its  turn,  is  divided  into 
machines  proper,  shafting,  belting,  piping,  electric  wir- 
ing and  furniture  and  miscellaneous  apparatus.  Special 
small  tools,  dies,  moulds,  lasts,  patterns,  drawings,  etc., 
are  treated  independently.  The  figures  for  each  of  the 
above  subjects  are  based  on  replacing  new  at  today's 
market  (regardless  of  original  cost)  and  are  then  depreci- 
ated as  judgment  dictates.  I  will  confine  myself  to 
describing  our  method  of  obtaining  this  new  value 
before  explaining  our  rules  for  depreciation. 

THE  USELESSNESS  OF  ELABORATE  DETAIL 

To  begin  with  the  appraisal  of  buildings,  I  wish  to 
still  further  emphasize  the  uselessness  of  extended 
detail.  Is  the  value  of  a  building  constructed  today, 
its  exact  cost?  Not  necessarily.  Let  us  suppose  that 
you  prepare  plans  and  call  for  competitive  bids.    One 


184 


THE      UTILITIES      MAGAZINE 


contractor  is  so  eager  for  the  work  that  he  is  willing  to 
do  it  at  a  figure  barely  above  cost  and  bids  $45,000. 
Another  contractor  is  already  overcrowded  and  does 
not  care  for  the  work  unless  he  can  obtain  a  large 
profit.  He  bids  $55,000.  Others  submit  figures  in 
between.  Let  us  suppose  that  you  decide  to  erect  two 
buildings,  awarding  one  contract  to  the  highest  bidder 
and  one  to  the  lowest.  You  obtain  two  buildings 
identical  in  every  respect,  yet  it  could  not  be  claimed 
that  one  was  worth  $55,000  and  the  other  $45,000. 
An  appraiser  who  estimated  each  building  worth 
$50,000  would  be  much  nearer  the  truth. 

This  is  still  further  emphasized  in  the  cost  of  founda- 
tions. Let  us  suppose  that  you  build  two  factories  for 
rental.  They  are  alike  in  every  detail  and,  above 
ground,  cost  the  same.  In  building  one,  a  solid  ledge 
is  discovered  eight  or  ten  feet  below  grade  and  the 
foundations  laid  thereon  at  a  minimum  of  expense. 
In  building  the  other,  quicksands  are  met,  necessitating 
the  driving  of  piles  over  the  entire  area,  incurring  a 
cost  of  several  thousands  in  excess  of  the  first.  Con- 
sider that  these  two  factories  have  equal  facilities  in 
regard  to  railroad  sidings  and  streets  and  are  the  same 
distance  from  the  business  center,  the  rent  charged 
must  be  the  same,  compelling  you  to  be  satisfied  with 
a  smaller  return  on  the  investment  for  the  one  with  the 
expensive  foundations.  If  you  wish  to  sell,  no  pro- 
spective customer  would  recognize  this  difference  in 
cost  and,  if  inclined  to  offer  more  for  either,  it  would  be 
in  favor  of  the  less  expensive  one  on  account  of  the 
foundations  being  more  stable.  Most  tax  assessors, 
could  they  learn  the  cost,  would  want  you  to  pay  the 
highest  tax  on  the  building  that  gives  the  lowest  net 
return.  An  appraiser,  however,  to  give  a  fair  and 
reasonable  estimate  must  consider  the  buildings  as  of 
the  same  value. 

In  making  insurance  appraisals  we  do  not  include 
cost  of  foundations  as  they  are  not  liable  to  damage 
from  fire  but,  in  cases  where  the  assured  wish  a  separate 
report  on  uninsurable  property,  we  invariably  estimate 
the  value  of  foundations  at  a  figure  that  ought  to  build 
them  under  normal  conditions  and  waste  no  time  in 
endeavoring  to  ascertain  their  actual  extent. 

THE  SQUARE  FOOT  BASIS  FOR  ESTIMATING 
VALUE  OF  BUILDINGS 

The  valuations  of  buildings  as  made  by  our  depart- 
ment are  based  on  the  square  foot  of  floor  area.  Many 
architects  and  engineers  use  the  cubic  foot  of  contents. 
Both  systems  are  good,  but  it  is  floor  space  rather  than 
cubic  contents  which  gives  manufacturing  facility,  and 
having  adopted  one  and  gathered  data  on  that  basis, 
it  is  better  to  confine  ourselves  to  it. 

As  a  groundwork  we  have  used  the  tables  prepared 


by  Mr.  Charles  T.  Main,  the  well-known  engineer,  for 
brick  buildings  with  plank  on  timber  floors  and  roofs, 
one  to  six  stories  high,  and  with  a  wide  range  of  lengths 
and  widths.  It  is  needless  to  state  that,  other  things 
being  equal,  the  price  per  square  foot  decreases  as  the 
length  and  width  increase.  I  will  repeat  that  those 
figures  form  only  a  groundwork.  They  must  be 
changed  for  different  heights  of  stud,  degrees  of  finish, 
thickness  of  wall,  etc.,  and  for  the  constant  fluctuations 
in  the  market  value  of  labor  and  materials. 

During  recent  years,  particularly  the  past  ten  years, 
numerous  different  types  of  construction  have  come 
into  use — steel  frame,  many  varieties  of  reinforced 
concrete,  hollow  tile,  combinations  of  the  above  with 
brick,  etc.  These  are  still  so  new  that  no  settled  rule 
has  been  developed,  as  actual  costs  show  no  consistency. 
Promotors  of  the  different  systems  have  taken  con- 
tracts at  absurdly  low  figures  for  the  sake  of  establish- 
ing examples  while,  on  the  other  hand,  contractors  not 
familiar  with  a  given  type  have  charged  exorbitant 
prices  to  be  sure  to  protect  themselves.  If  an  appraiser 
should  take  the  time  to  measure  the  amount  of  materials 
in  one  of  these  modern  buildings  and  then  try  to 
estimate  the  cost,  he  would  be  more  wild  in  his  con- 
clusions than  he  would  be  in  figuring  a  standard  brick 
building.  We  have  endeavored  to  cull  out  such  actual 
costs  as  seemed  reasonable,  apply  the  square  foot 
method,  using  the  tables  to  obtain  proportionate  fac- 
tors as  lengths  and  widths  varied. 

METHODS  OF  MACHINERY  INVENTORY 

Having  shown  how  the  new  value  of  buildings  can 
be  accurately  ascertained  by  a  comparatively  hasty 
inspection  and  by  quick  figuring,  I  will  now  describe 
our  method  of  appraising  machinery. 

It  is  our  custom  to  make  a  complete  physical  inven- 
tory of  all  fixed  machines,  enumerating  only  such 
dimensions  and  such  abbreviated  description  as  are 
necessary  to  determine  the  value.  For  a  cotton  spin- 
ing  frame,  for  instance,  "one  ring  frame  256  sp.  3"  met. 
bds.  sep."  means  a  ring  frame  with  256  spindles,  3"gauge 
with  metallic  thread  boards  and  separators.  "One 
engine  lathe  14  x  6  comp.  taper"  means  an  engine  lathe 
with  14-inch  swing,  6-foot  bed  over  all,  screw  cutting, 
without  special  gearing,  with  compound  rest  and  taper 
attachment.  Other  special  features  that  materially 
affect  the  cost  are,  of  course,  noted.  In  each  case  the 
above  brief  notes  will  determine  the  value  just  as  accu- 
rately as  half  a  page  of  detailed  description  with  the 
added  advantage  that  in  later  perusal  of  the  notes, 
each  machine  can  be  much  more  readily  identified. 
By  adhering  to  this  method,  the  fixed  machines  in  a 
large  factory  can  be  inventoried  in  an  incredibly  short 
time. 


VALUATION      BY      APPROXIMATION 


185 


METHOD  OF  APPRAISAL  FROM  INVENTORY 

All  standard  machines  are  appraised  by  price  list. 
This  is  possible  with  the  greater  part  of  textile,  metal 
and  wood  working,  shoe  machinery  and  several  other 
types.  All  special  machines,  where  the  owners  have 
no  recorded  costs,  must  be  estimated.  Paper  machin- 
ery and  to  a  great  extent  bleachery  and  rubber  mill 
machinery  is  built  especially  and  must  be  appraised 
from  data  obtained  by  experience.  The  prices  used 
for  all  machines  are  then  increased  from  5  to  10  per 
cent,  as  judgment  dictates,  to  cover  the  cost  of  freight, 
cartage  and  labor  of  erection.  I  would  not  create  the 
impression  that  we  arbitrarily  affix  prices  to  all  ma- 
chines. We  welcome  a  conference  with  the  owner  in 
which  we  can  obtain  actual  costs,  bearing  in  mind, 
however,  that  no  figure  should  be  incorporated  in  the 
appraisal  unless  we  are  satisfied  that  it  is    reasonable. 

Of  the  value  of  buildings  and  contents  we  find  that 
the  value  of  buildings  and  fixed  machines  ordinarily 
amounts  to  more  than  half  of  the  value  of  the  total,  if 
the  figures  for  special  small  tools,  patterns,  etc.,  and 
stock  be  temporarily  excluded;  in  some  cases  much 
more  than  half. 

Considering  that  the  data  for  buildings  and  machines 
have  been  obtained  in  so  short  a  time,  it  would  be 
inconsistent  to  spend  several  times  that  amount  in 
listing  the  minor  items  in  fine  detail.  It  is  here  that 
we  have  developed  what  one  might  term  short  cut 
methods.  I  will  take  up  the  subjects  in  the  order 
previously  mentioned. 

SHAFTING 
If  one  were  to  list  every  pulley,  hanger,  etc.,  and 
price  each  item,  it  would  take  longer  than  to  do  the 
same  work  with  machines.  An  amount  for  erection 
would  still  have  to  be  estimated  and  it  would  form  a 
far  larger  proportion  than  would  the  figure  for  erection 
of  machines.  The  grand  total  obtained  would,  how- 
ever, seldom  exceed  5  per  cent  of  the  machine  value. 
We  simply  estimate  a  price  per  lineal  foot,  obtained 
from  actual  figures,  for  the  shafting  all  equipped  and 
erected,  varying  the  factor  as  conditions  warrant. 

BELTING 

Main  belts  can  be  quickly  measured  by  eye.  Ma- 
chine belts,  so  much  per  machine,  classified  into  several 
groups.  Wherever  we  have  had  a  chance  to  compare 
our  results  with  a  painstaking  inventory  with  tape  line 
measurements,  made  by  the  owner,  the  money  value  has 
always  been  practically  the  same,  due  to  the  before- 
mentioned  law  of  averages. 

PIPING 

The  subject  of  piping  must  be  somewhat  subdivided. 
With  automatic  sprinkler  piping,   I   must  emphasize 


that  it  is  absolutely  foolish  to  waste  time  measuring 
each  size  of  pipe,  counting  elbows,  tees,  etc.,  and  then 
estimating  the  amount  for  erection.  Every  sprinkler 
contractor  risks  his  chance  for  profit  by  figuring  so 
much  per  spinkler  head  for  the  work  erected  and  we 
follow  the  same  method  when  the  number  of  heads 
is  easily  obtainable.  In  most  cases,  however,  we  allow 
so  many  cents  per  square  foot  of  floor  area  as  the  result 
is  the  same.  This  applies,  of  course,  only  to  piping 
inside  the  buildings.  For  steam  and  hot  water  heating 
piping,  we  use  a  similar  method,  except  in  unusual 
cases.  Gas  lighting  is  not  common  today,  but  can  be 
treated  in  the  same  manner. 

Steam,  water,  gas,  oil  and  air  piping  for  manufactur- 
ing purposes  is  treated  on  even  broader  lines;  for  a 
detailed  inventory,  particularly  in  the  case  of  a  large 
paper  mill  or  bleachery,  would  take  a  prohibitive 
amount  of  time.  Taking  an  amount  for  each  machine 
supplied  and  using  as  a  cross  check  so  much  per  horse 
power  for  steam  and  general  factors  for  the  others, 
according  to  the  nature  of  the  plant,  a  sufficiently 
accurate  result  is  obtained. 

ELECTRIC  WIRING 

Electric  wiring  is  figured  at  so  much  per  light  and  so 
much  per  horse  power  of  motors,  varying  the  factors 
for  each  variety  of  light  and  compiling  the  horse  power 
in  groups  as  the  sizes  range  from  small  to  large. 

FURNITURE  AND  APPARATUS 

The  great  mass  of  miscellaneous  equipment,  exclusive 
of  special  small  tools,  etc.,  we  term  furniture  and 
apparatus.  In  a  cotton  mill  this  can  be  accurately 
estimated  at  a  price  per  spindle  and  in  a  woolen  mill 
fairly  accurately  at  a  price  per  set  of  cards. 

It  is  better,  if  possible,  to  obtain  from  the  foremen 
of  the  different  departments,  their  estimate  in  round 
numbers  of  the  amounts  of  bobbins,  spools,  boxes, 
trucks,  etc.,  figure  them  at  market  rates  and  give  a 
quick  estimate  on  benches,  tables,  racks,  etc.,  in  each 
room.  In  a  metal  working  plant,  it  is  easy  to  obtain 
the  total  number  of  tote  boxes,  cans  and  trucks;  apply 
a  figure  per  lineal  foot  to  benches  and  racks  and  estimate 
the  value  of  what  other  miscellany  there  is.  In  most 
plants  the  total  amount  of  office  furniture  is  not  worth 
as  much  as  the  combined  value  of  a  few  of  the  most 
expensive  machines  and  it  can  be  quickly  estimated 
without  listing. 

SMALL  TOOLS 

In  all  machine  shops,  one  meets  with  special  small 
tools  that  are  worth  about  so  much  per  producing 
machine,  varying  from  a  small  amount  in  a  jobbing 
repair  shop  to  a  high  figure  in  a  typewriter,  firearms 
or  watch  factory.     If  an  appraiser  should  take  his  time 


186 


THE      UTILITIES      MAGAZINE 


to  inventory  all  these  items  in  detail,  it  would  take 
longer  than  all  the  rest  of  the  work,  yet  he  would  have 
no  accurate  prices  to  use  but  would  have  to  estimate 
the  value  of  each  item.  A  much  surer  way  is  to  make 
a  broad  gauge  estimate  as  above  described  and  then 
discuss  the  matter  with  the  owner,  making  such  changes 
as  his  records  and  his  judgment  seem  to  warrant.  The 
same  method  is  applied  to  metal  stamping  dies. 
Moulds  in  a  rubber  mill  can  be  treated  in  a  similar 
manner,  though  usually  the  owner  will  have  a  pretty 
comprehensive  list.  Lasts  are  almost  invariably  carried 
on  accurate  inventory. 

The  easiest  method  with  foundry  patterns  is  to  apply 
a  factor  per  square  foot  of  shelf  area.  With  drawings, 
ascertain  the  number  of  years  it  has  taken  to  accumu- 
late the  drawings  considered  of  practical  value,  the 
number  of  draftsmen  employed  each  year,  apply  a 
price  per  man  that  will  cover  salary  and  overhead 
expense  and  deduct  a  percentage  (agreed  to  by  the 
owner  of  the  plant)  for  time  spent  on  experimental 
work,  for  the  value  of  a  drawing  is  only  the  mechanical 
cost  of  replacing  as  all  measurements  can  be  obtained 
from  finished  machines  in  existence. 

Print  rolls  in  a  cloth  print  works  or  wall  paper  factory 
and  dandy  rolls  in  a  paper  mill  are  always  kept  on 
inventory  and  their  value  can  be  easily  determined  by 
consultation  with  the  owner.  Electrotypes  average 
so  many  cents  per  square  inch  and  being  kept  on  shelves 
or  in  drawers,  the  number  of  square  inches  can  be 
quickly  estimated.  All  other  extras  peculiar  to  the 
plant  in  question  can  be  appraised  by  some  one  of  the 
foregoing  methods.  It  is,  perhaps,  needless  to  remark 
that  we  never  attempt  to  appraise  stock  and  supplies 
(barring  extreme  cases)  preferring  to  average  the  inven- 
tories of  the  owner  to  obtain  the  value. 

STILL  QUICKER  METHODS 

I  have  described  the  short  cut  methods  we  usually 
employ.  In  cases  where  a  quick  rough  figure  is  desired, 
we  simply  use  a  general  factor  such  as  per  spindle  in  a 
cotton  mill,  per  set  of  cards  in  a  woolen  mill,  per  square 
foot  of  floor  area  or  per  producing  machine  in  any 
standard  plant. 

DEPRECIATION 

But  after  all  of  the  above  subjects  have  been 
satisfactorily  appraised,  it  matters  not  whether  by 
long  painstaking  detail  (which  I  reassert  is  a  waste  of 
time),  whether  by  the  shorter  method  that  we  employ 
or  whether  by  the  rough  general  method  just  described, 
there  remains  the  great  subject  of  depreciation  which 
has  caused  more  argument  and  discussion  than  all  the 
others  combined.  As  it  is  almost  universally  conceded 
that  depreciation  is  deserved  if  wear  has  been  sustained, 
I  will  not  take  time  here  to  argue  that  question.     The 


difference  of  opinion  among  men  competent  to  give  an 
opinion  as  to  what  percentage  should  be  allowed  for 
depreciation  amounts  to  more  in  money  value  than  any 
error  thai  can  be  made  reasonably,  in  estimating  the  new 
value,  regardless  of  the  method  used. 

In  the  case  of  a  second-hand  proposition  where  it  is 
merely  an  offer  to  be  made  for  a  defunct  property,  the 
intended  purchaser  can  simply  deduct  one  half  or  two 
thirds  or  more  and  the  matter  is  ended.  In  the  case  of 
an  owner  wanting  to  carry  the  value  of  his  plant  on 
his  books  as  an  asset  and  at  a  conservative  figure,  it  is 
best  to  deduct  a  certain  percentage  each  year  and  the 
usual  practice  is  to  vary  this  from  5  to  10  per  cent.  In 
many  cases,  nothing  is  deducted  in  a  poor  year  and  a 
large  amount  is  deducted  in  a  good  year,  but  a  stated 
annual  amount  is  undoubtedly  better  practice. 

GOING  CONCERN 

In  making  our  insurance  valuations  we  have  to  con- 
sider the  plant  as  a  going  concern  and  that  the  machin- 
ery, no  matter  how  antiquated,  is  turning  out  salable 
product  for  the  owner.  Our  depreciations,  therefore, 
represent  what  in  our  judgment  the  machines  have 
really  lost  in  wear  and  tear  or  in  going  out  of  date  and, 
in  per  cent  of  new  value,  are  less  than  would  be  applied 
for  any  other  purpose. 

DEPRECIATION  OF  BUILDINGS 

Let  us  first  treat  the  depreciation  on  buildings. 
When  one  is  more  than  three  or  four  years  old,  has 
remained  plumb,  is  kept  in  repair  and  is  of  such  dimen- 
sions that  it  perfectly  answers  the  purpose  for  which  it 
is  used,  we  consider  that  the  depreciation  does  not 
increase  but  stands  constant  at  5  per  cent  of  total  new 
value  for  a  good  many  years.  When,  however,  a  build- 
ing in  good  repair  is  of  such  dimensions  that  it  is 
manifestly  out  of  date  and  unsuited  to  obtain  best 
results  for  its  occupancy,  we  increase  the  depreciation. 
Naturally  a  building  not  kept  in  repair  is  depreciated 
much  more  heavily. 

DEPRECIATION  OF  MACHINERY 

With  machines  we  vary  the  depreciation  with  the 
class.  An  engine,  or  boiler,  nearly  any  textile  machine, 
is  used  year  after  year  with  minor  repairs  until  the  time 
comes  when  it  is  thrown  out  altogether  to  make  room 
for  a  new  one.  In  such  cases  we  ascertain  the  age  and 
deduct  an  annual  percentage  varying  from  2  to  5  per 
cent  according  to  the  average  life  of  the  machine,  but 
seldom  carry  the  total  depreciation  to  a  figure  beyond 
50  per  cent.  As  has  been  stated,  we  start  with  the 
replacing  cost  new  today  and  our  annual  deduction  is 
from  the  net  and  not  the  gross.     In  bookkeeping  the 


VALUATION      BY      APPROXIMATION 


187 


practice  is  usually  to  deduct  the  annual  percentage 
from  the  first  cost. 

There  is  a  vast  number  of  machines,  particularly 
those  that  are  automatic,  where  the  main  portion, 
sometimes  as  much  as  80  per  cent  of  the  total  value, 
remains  for  years  with  practically  no  wear,  while  the 
small  moving  parts  wear  out  so  rapidly  that  they  are 
constantly  being  replaced.  With  these  machines  we 
consider  that  the  wearing  parts  are  always  in  a  state  of 
50  per  cent  depreciation  and  so  make  the  figure  on  the 
lot,  half  of  the  percentage  the  wearing  parts  bear  to  the 
whole.  In  the  case  of  a  paper  machine  that  is  made  up 
of  numerous  sections  and  will  vary  from  50  to  200  feet 
long  and  from  $15,000  to  $125,000,  age  has  very  little 
influence,  for,  from  time  to  time,  whole  sections  have 
been  removed  and  replaced,  while  other  parts,  one 
might  say,  never  wear  out.  Our  depreciation  in  such 
cases  is  based  entirely  on  general  conditions. 

DEPRECIATION  OF  SHAFTING,   ETC. 

Shafting  shows  such  slight  wear  that  depreciation  is 
practically  never  recognized.  Main  belts  wear  slowly 
while  machine  belts  are  always  in  a  state  of  50  per  cent 
depreciation  so  we,  as  a  rule,  consider  33^  per  cent  a 
fair  average  for  belting  as  a  whole.  Piping,  where 
exposed  to  acid  fumes,  disintegrates  rapidly,  but  gen- 
erally the  valves  and  pipe  covering  are  the  only  parts 
that  show  any  appreciable  wear.  We,  therefore,  seldom 
allow  a  depreciation  of  more  than  10  per  cent  of  the 
whole.  Electric  wiring  wears  little  and  the  rigid  rules 
of  both  local  authorities  and  insurance  companies  com- 
pel its  being  kept  pretty  well  up  to  date  so  that  the 
total  depreciation  is  always  light. 

A  majority  of  the  objects  making  up  the  subject  of 
furniture  and  apparatus  are  wearing  out  all  the  time 
and  we  deduct  from  20  to  50  per  cent.  The  same 
applies  to  special  small  tools  and  dies  though  here  the 
depreciation  is  influenced  by  the  proportion  of  the  total 
that  has  become  out  of  date.  Moulds,  lasts,  patterns 
and  drawings  are  affected  almost  wholly  by  the  latter 
reason.  Print  rolls  and  electrotypes  are,  like  small 
tools,  affected  by  both. 


IN  CONCLUSION 

I  have  endeavored  to  give  in  as  few  words  as  possible 
a  description  of  the  methods  we  employ  that  enable  us 
to  make  an  accurate  appraisal  of  a  manufacturing 
property  in  a  very  few  days  of  actual  field  work  and  a 
few  more  of  work  in  the  office.  I  cannot  close,  how- 
ever, without  making  a  more  definite  reference  to  the 
system  of  making  inventories  in  such  extreme  detail, 
which  system  is  best  illustrated  by  the  work  of  the 
appraisal  companies.  It  is,  perhaps,  needless  to  ex- 
plain that  as  our  valuations  are  made  free  to  the  assured, 
we  are  not  in  competition  with  any  one  and  it  is  abso- 
lutely immaterial  to  us  whether  one  of  these  companies 
is  employed  or  not. 

We  have  had  the  opportunity  again  and  again  to 
examine  the  records  of  such  appraisals.  Invariably 
there  is  a  finely  prepared  volume,  giving  in  minute 
detail  a  list  of  everything  on  the  premises.  It  is  always 
overburdened  with  unimportant  description  that  is 
not  necessary  to  determine  value  and  only  serves  to 
confuse  one  who  is  searching  for  individual  items.  In 
cases  where  we  have  had  the  time  to  make  a  detailed 
examination,  we  have  always  found  the  usual  propor- 
tion based  on  estimate  only  and  errors  large  enough  to 
counterbalance  the  value  of  whole  pages  of  minor  items 
so  laboriously  collected.  These  errors  do  not  materi- 
ally affect  the  final  result,  as  the  law  of  averages  takes 
care  of  that,  and  it  leaves  the  final  figures  no  more  accurate 
than  those  of  our  appraisal  made  by  a  shorter  method. 

The  claim  is  made  that  the  courts  will  not  recognize 
an  appraisal  unless  made  in  fine  detail.  I  think,  how- 
ever, it  would  take  very  little  effort  to  demonstrate  to 
any  court,  the  large  extent  to  which  estimate  had 
entered  into  any  appraisal  and  that  an  appraisal  made 
on  broad  common  sense  lines  can  be  just  as  accurate  as  one 
made  in  great  detail. 

Our  valuations  are  not  made  for  cases  before  the 
court  and  personally  I  have  been  able  to  avoid  mixing 
in  such  arguments.  Two  of  my  associates,  however, 
have  had  to  give  testimony  based  on  appraisals  they 
had  made  by  our  methods  and  the  results  were  in  each 
case  satisfactory. 


DISCUSSION 


Bt  Alexander  Potteb 

Coruulting  and  Constructing  Engineer,  New  York  City 

The  author's  paper  deals  with  one  special  phase  of  the 
subject  of  valuation  of  properties,  namely,  the  determination 
of  the  commercial  physical  value  of  factories. 

The  writer  not  only  agrees  with  the  author  that  "valuation 
by  approximation"  is  possible  in  such  cases  as  are  specially 


referred  to  in  the  author's  paper,  but  he  is  of  the  opinion 
that  "valuation  by  approximation"  might  very  properly  be 
extended  to  include  the  determination  of  present  values  of 
works  of  greater  magnitude  than  factory  buildings  and 
machinery. 


188 


THE      UTILITIES      MAGAZINE 


It  cannot  well  be  gainsaid  that  many  of  the  important 
appraisals  and  valuations  now  being  conducted  in  connection 
with  the  various  railroads  throughout  the  country  are  involv- 
ing so  much  detailed  examination  and  survey  that  the  time 
required  for  this  investigation  as  well  as  the  time  that  will 
be  required  for  conferences  between  the  representatives  of 
the  government  and  the  railroads,  not  to  mention  the  time 
and  delay  of  court  proceedings  that  will  ultimately  follow  in 
connection  therewith,  renders  such  valuations  more  or  less 
valueless  because  of  changes  in  conditions  between  the  time 
that  the  work  was  started  and  when  finally  adjudicated  by  the 
courts. 

It  would  seem  to  the  writer,  therefore,  that  an  effort  to 
procure  "  valuation  by  approximation  "  by  determining  some 
general  relationship  between  the  factors  which  tend  to  reduce 
the  actual  value  of  the  plant,  such  as  depreciation,  and  those 
factors  which  tend  to  increase  the  actual  value  of  the  plant, 
such  as  going  concern,  interest  during  construction,  develop- 
ment charges,  etc.,  is  justifiable,  and  if  such  a  relationship 
can  be  established,  even  though  it  might  be  approximate, 
the  time  element  and  the  expense  of  the  valuation  itself  thus 
saved  wiU  oftentimes  be  more  important  factors  than  the 


refinements  in  valuation  which  can  be  brought  about  by  an 
additional  expenditure  of  time  and  the  employment  of  high- 
priced  experts  on  behalf  of  the  government  and  the  private 
corporations. 

In  cases  of  valuation  upon  which  the  writer  has  been 
retained  there  has,  in  fact,  existed  a  certain  relation  between 
these  two  sets  of  factors.  The  ratio,  while  not  always  the 
same,  has  been  so  approximately  the  same  as  to  raise  in  his 
mind  the  question  whether  or  not  substantial  justice  could 
not  be  done  to  both  parties  by  the  application  of  "valuation 
by  approximation."  There  are  so  many  commissions  now  at 
work  on  valuing  railroad  properties  and  water  works  and 
other  large  utilities  that  from  these  valuations  now  going  on 
sufficient  data  could  be  procured  to  establish  the  truth  or 
falsity  of  the  statement  that  a  ratio  can  be  so  fixed  that  in 
the  future  such  expensive  valuations  as  are  now  in  progress 
can  be  avoided  and  results,  approximately  as  reliable,  secured. 

The  saving  that  will  result  if  this  theory  is  true  warrants 
an  investigation  on  the  part  of  some  central  organization, 
such  as  The  Utilities  Bureau,  under  whose  auspices  the 
valuable  symposium  of  papers  on  the  valuation  of  public 
utilities  has  been  prepared. 


DISCUSSION 

Morris  Llewellyn  Cooke 
Director  0/  PuUic  Works,  Philadelphia 


While  being  an  absolute  layman  in  this  matter  of  inven- 
tories I  have  had  two  contacts  with  the  subject  which  perhaps 
warrant  me  in  taking  a  few  minutes  of  your  time.  Owing 
to  my  being  an  industrial  engineer  I  have  had  more  than 
an  ordinary  opportunity  to  judge  the  attitude  of  the  average 
manufacturer  toward  his  inventory.  On  the  other  hand,  as 
Director  of  Public  Works,  I  have  seen  at  close  range  the 
attitude  of  the  owners  of  public  utilities  towards  the  valua- 
tion of  their  properties.  The  views  of  the  manufacturer 
and  the  public  utility  owner  are  absolutely  dissimilar.  I 
have  always  thought  that  in  a  manufacturing  plant  the 
importance  of  the  inventory  was  underestimated.  It  is 
almost  impossible,  in  an  industrial  plant, — at  least  in  those 
with  which  I  have  been  associated — to  have  the  inventory 
properly  maintained,  or  even  viewed  with  any  considerable 
respect.  There  is  very  little  attention  paid  to  it  or  interest 
taken  in  it. 

On  the  other  hand,  with  the  utilities,  as  I  have  come  in 
contact  with  them,  too  much  of  the  whole  problem  is  wrapped 
up  in  the  question  of  valuation.  Now,  of  course,  in  my 
position,  it  has  been  necessary  for  me  to  assume  almost  the 
position  of  appearing  to  combat  these  valuations.  Espe- 
cially in  the  case  of  the  Philadelphia  Electric  Company  I 
have  been  forced  to  oppose  strenuously  what  appears  to  be  a 
highly  inflated  valuation.  Now,  I  have  no  disposition,  at 
least  I  hope  I  have  none,  to  fight  the  truth.  But  it  does  seem 
to  me  that  the  truth  in  the  matter  of  the  valuations  of  utilities 
is  usually  led  in  somewhat  shackled. 

There  is  one  difference  between  an  industrial  valuation 


and  a  utility  valuation  that,  of  course,  we  must  recognize. 
The  total  income  of  the  Philadelphia  Electric  Company 
during  the  year  is  about  $8,000,000  so  that,  taking  a  low 
valuation,  20  to  30  millions,  or  a  valuation  that  is  nearly  what 
the  city  thinks  it  ought  to  be,  their  total  income  is  only 
one  third  to  one  quarter  of  such  valuation.  If  you  accept  the 
valuation  that  possibly  may  be  put  upon  it  by  the  typical 
valuation  engineer,  it  would  still  be  one  fifth  or  one  sixth 
of  it.  Now  I  know  of  no  industrial  operation  where  the  total 
gross  income  represents  such  a  relatively  small  proportion  of 
the  total  value  of  the  plant.  This  is  one  good  reason  that  you 
apparently  cannot  argue  away  as  to  why  the  utilities  should 
spend  more  time  on  this  feature  of  the  inventory  and  why 
they  place  so  much  importance  upon  it. 

The  uses  of  the  industrial  inventory,  as  I  see  it,  are  two: 
first,  for  the  bklance-sheet  in  order  to  be  able  to  put  a  little 
book  under  your  arm  once  in  a  while  and  go  down  to  the 
bank  and  make  a  convincing  demonstration;  and  the  other, 
is  to  make  it  possible  to  obtain  accurate  costs.  The  utility 
has  this  first  use  for  an  inventory,  i.e.,  for  the  purposes  of 
the  balance-sheet  including  rate  making,  borrowing  money, 
issuing  securities,  etc.  But  up  to  date  practically  no  utility 
company  has  used  its  inventory  to  get  costs.  I  know  that 
this  remark  will  be  resented  by  those  administrating  our 
utilities.  Broadly  speaking,  however,  there  is  no  such 
thing  as  cost-keeping  in  the  utility  field  today.  The  fact 
that  there  is  one  company  that  has  a  very  splendid  system  of 
costs  and  that  there  are,  perhaps,  3  to  5  per  cent  of  them 
that  are  feeling  their  way  toward  a  proper  system  of  costs. 


VALUATION      BY      APPROXIMATION 


189 


can  hardly  be  taken  as  invalidating  the  general  statement  as 
to  the  absence  of  cost  work. 

So  that  any  claim  on  the  part  of  the  utilities  as  to  the 
necessity  of  a  particular  scheme  of  making  valuations  on 
account  of  its  effect  upon  cost-keeping,  is  not  worth  very 
much  from  an  industrial  or  an  economic  standpoint.  As  a 
matter  of  fact  the  utility  companies  do  not  recognize  the 
necessity  for  cost-keeping  and  they  have  no  adequate  con- 
ception of  what  costs  are.  I  hope  those  of  you  who  do  not 
agree  with  me  on  that  point  will  be  kind  to  me  in  your  judg- 
ments; because  I  am  quite  sure  if  I  had  the  opportunity  I 
could  demonstrate  that  what  I  have  said  is  true. 

Now  let  me  say  a  word  as  to  this  question  of  detail  in 
making  inventories  and  appraisals.  Within  a  month  I  have 
had  the  opportunity  of  going  over  a  recently  compiled  valua- 
tion of  an  important  utility  property;  I  was  surprised  to  see 
one  item  in  that  valuation.  True,  it  may  not  be  typical; 
but  it  certainly  fairly  represents  a  tendency.  The  appraisers 
had  gone  into  a  power  plant  to  inventory  that  power  plant 
and  had  measured  one  4-foot  section  of  2-inch  pipe,  and  then 
they  had  appraised  separately,  not  only  the  section  of  pipe 
itself,  but  the  two  threads  on  either  end  of  that  piece  of  pipe — 
the  latter  at  18  cents  each.  Now,  can  you  beat  that?  It  is 
like  inventorying  this  room  by  counting  the  number  of 
boards  in  the  floor,  or,  perhaps,  the  particles  of  plaster  on  the 
wall. 

It  is  only  fair  to  state  that  if  one  party  to  the  issue  starts 
inventorying  in  such  detail  the  other  side  is  forced  to  do 
it.  In  other  words,  if  any  pubHc  or  private  interest  in  this 
matter  starts  to  inventory  in  any  such  detail  as  that,  under 
present-day  conditions,  it  will  probably  be  necessary  for  the 
opposing  interest  to  do  the  same.  If  they  get  to  a  clash  on 
any  particular  point,  each  will  thus  have  the  material  with 
which  to  meet  the  other's  argument. 

Another  tendency  in  this  field  that  seems  to  me  to  be 
absolutely  wrong  is  the  unwillingness  of  valuation  engineers 
to  produce  the  supporting  data  on  which  details  of  valuations 
are  made.  There  are  cases  on  record  where  valuation  engi- 
neers have  gone  into  the  power  plant  and  other  parts  of  the 
physical  property,  and  have  Ksted  things  with  the  greatest — 
almost  a  disgust'ng  amount— of  detail,  and  then  not  only  put 
in  a  lump  sum  in  the  appraisal  but  when  the  supporting 
details  were  called  for  refused  to  give  them. 

I  think  every  speaker  on  this  subject  has  claimed  that  it  is 
necessary  to  know  for  what  purpose  an  inventory  is  being 
made.  This  seems  to  me  to  be  fundamentally  wrong.  In 
making  an  inventory  of  an  industrial  plant,  you  list  every- 
thing in  it,  and  put  a  value  on  it.  Then  for  one  use  you  take 
one  group  of  those  values,  and  for  another  use  you  take 
another  group.  For  instance,  after  you  have  ascertained 
the  value  of  the  power  plant  in  a  printing  establishment  you 
determine  its  bearing  on  the  work  of  the  different  depart- 
ments. You  will  find  out,  for  instance,  that  in  your  type- 
setting department,  where  there  is  very  little  power  used, 
the  cost  factor  attributable  to  the  power  plant  is  almost 
negligible.  In  the  press  room,  however,  where  the  power  is  a 
big  factor,  it  has  that  much  more  weight.    You  simply  appor- 


tion the  power-plant  expense  to  the  different  departments, 
according  to  the  demands  made  by  them  upon  it.  So  it 
seems  to  me  that  in  these  utility  properties  we  should  simply 
make  the  inventory  and  then  use  that  part  of  it  that  should 
be  used  in  connection  with  each  particular  inquiry. 

I  am  disposed  to  disagree  with  Mr.  Pillsbury  as  to  the 
necessity  for  outside  supervision  in  the  maintenance  of  in- 
ventories. I  know  that  it  is  a  theory  with  some  people  that 
you  cannot  have  anything  done  right  unless  it  is  checked  up 
by  somebody  from  the  outside.  It  seems  to  me,  however, 
that  we  want  to  look  forward  to  building  up  industrial  organi- 
zations and  utility  organizations  that  can  keep  up  things 
that  we  have  once  decided  we  want  to  have  kept  up, 
and  this  without  outside  help.  We  must  not  decry  the  use 
of  the  expert  because  he  may  be  absolutely  necessary  in  start- 
ing these  things.  To  do  this  we  frequently  must  bring  in 
men  from  the  outside  who,  like  Mr.  Pillsbury,  are  especially 
qualified  on  such  work.  But  I  don't  believe  that  in  the  long 
run  inventories  and  appraisals  will  be  properly  made  and 
maintained  by  the  utilities  until  they  have  skilled  and  regu- 
lar employees  who  consider  it  just  as  much  a  part  of  their 
work  to  maintain  them,  and  maintain  them  properly,  as  it  is 
to  maintain  other  parts  of  the  service  and  maintain  that 
service  properly. 

Another  point  that  has  been  made  and  with  which  I 
heartily  disagree  is  that  utility  inventories  and  valuations 
are  more  complex  than  those  of  the  industries.  I  think  it 
will  help  clarify  this  situation  if  we  don't  just  assume  that 
utility  properties  are  so  much  more  complex  than  steel  works, 
or  printing  plants,  or  any  one  of  a  dozen  other  properties 
that  I  might  mention. 

Just  in  passing,  I  want  to  comment  on  a  remark  made  by  Mr. 
Meigs  this  morning.  Mr.  Meigs  said  that  his  difficulty  in  all 
these  matters  was  to  get  the  men  below  him  to  properly 
represent  his  company.  I  am  sure  that  this  must  be  the  case 
in  Mr.  Meigs'  company.  But  I  think  it  may  be  of  some 
value  for  the  purposes  of  this  record  to  say  that  all  my 
experience  with  the  utility  companies  is  exactly  the  opposite. 
In  my  relations  with  the  men  holding  subordinate  positions 
with  utility  companies  I  have  found  every  disposition  to 
co-operate  with  my  associates  and  with  me.  But  too  fre- 
quently these  holders  of  subordinate  positions  have  not  felt 
warranted  in  deciding  that  2  and  2  makes  4  without  disap- 
pearing for  a  half-hour  or  a  week  in  order  to  find  out  whether 
someone  on  the  third  floor  or  the  tenth  floor  really  thought  so. 

Frankly,  up  to  the  time  that  I  received  a  letter  from  Mr. 
John  R.  Freeman  about  the  work  that  Mr.  Morse  had  done 
for  the  New  England  Mutuals,  I  could  not  see  any  way  out  of 
this  valuation  maze.  We  are  carrying  on  a  rate  case  against 
the  Philadelphia  Electric  Company,  in  which  they  admit  that 
the  valuation  has  cost  in  the  neighborhood  of  $200,000. 
Now,  to  even  check  intelligently  an  inventory  costing 
$200,000  would  require  the  expenditure  of  a  very  large  sum 
of  money.  Our  situation  in  this  and  similar  cases  seemed 
to  me  perfectly  hopeless,  unless  our  city  devoted  simply  to 
this  one  matter  of  combating  its  utility  companies  a  very 
much  larger  percentage  of  its  total  income  than  it  had  the 
right  to  spend  on  any  such  object.     But  Mr.  Freeman  tells 


190 


THE      UTILITIES      MAGAZINE 


me  that  this  work  that  they  were  doing  in  his  company  has 
cut  the  cost  of  inventories  from  one  fifth  to  one  tenth.  I 
think,  perhaps,  it  is  a  misnomer  to  call  this  a  method  by 
approximation.  The  name  makes  it  appear  as  if  it  referred 
to  something  carelessly  done.  After  all,  any  method  that 
involves  measuring  a  4-foot  length  of  2-inch  pipe  and  esti- 
mating at  18  cents  each  the  two  threads  cut  on  either  end, 
is  a  method  by  approximation.  But  this  latter  seems  to  me 
to  be  a  method  by  approximation  on  a  more  sensible  basis. 


I  welcome  this  scheme  of  the  New  England  Mutuals,  and 
feel  that  we  can  all,  both  on  the  public  and  private  side, 
afford  to  spend  a  good  deal  of  time,  and  some  of  the  money 
that  is  going  into  the  making  of  these  more  attenuated  val- 
uations, to  see  whether  we  cannot  take  a  leaf  out  of  their 
book.  We  must  in  some  way  standardize  this  inventorying 
and  valuating  process,  to  the  end  that  we  cut  the  total  ex- 
pense which  is,  of  course,  ultimately  borne  by  the  public,  and 
not  by  the  investors  in  these  properties. 


CORRECT  VALUATION  OF  OPERATING  AND  MANAGERIAL  METHODS 

By  Walter  N.  Polakov 

Consulting  Engineer,  Stamford,  Conn. 


The  question  of  physical  valuation  of  public  utilities  is  a 
fairly  recent  one  and,  if  I  remember  it  right,  when  the  plank 
calling  for  valuation  of  railroads  was  in  1908  presented  to  the 
Republican  National  Committee  at  Chicago,  it  received  but 
thirty  votes  out  of  over  one  thousand,  and  was  voted  down 
amid  jeers  and  suggestions  to  "Take  it  to  Denver,"  "Send 
it  to  the  Socialists,"  etc.  Nevertheless,  several  state  valua- 
tions had  been  made  prior  to  this  date.  I  think  Michigan 
was  first  carrying  physical  valuation  of  public  utilities  in 
1900  for  taxation  purposes.  On  February  24,  1913,  as  you 
know,  the  Senate  passed  the  bill  calling  for  valuation  of 
interstate  railroads.  It  does  not  seem  now  that  anyone 
associated  with  the  passage  of  this  act  did  then  reaUze  the 
difiiculties  and  expenses  connected  with  the  executions  of  its 
provisions.  As  to  what  benefits  will  actually  accrue  from  it, 
there  was  even  no  mention  made.  Hon.  Charles  A.  Prouty 
stated  before  the  National  Association  of  Railroad  Commis- 
sioners at  Washington  in  November,  1914,  that  the  cost  of 
valuation  to  railroads  alone  would  possibly  be  $35,000,000 
and  to  the  government  about  one  half  as  much,  making  a 
total  of  over  $50,000,000.  Remember  that  only  a  few  months 
before  this  expense  was  estimated  at  $12,000,000.  In  other 
words,  while  original  estimates  of  valuation  cost  were  from 
$10  to  $25  per  mile  of  railroad,  now,  after  the  work  has  begun, 
Mr.  A.  P.  Russell,  Chief  of  Valuation  Department  of  the  N. 
Y.,  N.  H.  &  H.  R.  R.  Co.  says  it  is  likely  to  reach  $200  per 
mile  owned  or  operated  of  the  250,000  route-miles  of  railroads 
of  this  country. 

Now,  add  to  this  expense  those  borne  by  all  other  public 
utilities  and  try  to  answer  a  simple  question:  "What  will  be 
the  return  on  this  investment?  "  Will  the  freight  and  passen- 
ger tariff  be  lowered?  Will  the  rates  on  light  and  power  be 
reduced?    Will  the  manufacturing  cost  be  lowered? 

I  am  willing  to  assume  that  benefits  will  be  great  and 
many.  Then  the  question  is  simplified — "To  what  extent 
the  costly  refinement  and  minuteness  of  valuation  work  is 
warranted?  "  The  annual  report  of  the  Interstate  Commerce 
Commision  for  1912  estimates  the  value  of  railroads,  their 
equipment  and  cash  on  hand  at  about  $16,000,000,000. 
The  legal  rate  of  interest  on  this  amount  would  be  for  one 
year  $960,000,000.  Now  suppose  that,  owing  to  cheaper  and 
more  approximate  methods  of  valuation,  an  error  would  be 


made  as  great  as  5  per  cent;  the  interest  then  would  become 
not  $960,000,000  but  either  $912,000,000  or  $1,008,000,000. 
Now,  gentlemen,  to  make  my  point  clear,  compare  this  grave 
error  of  $48,000,000  a  year  with  $365,000,000  a  year  of  pre- 
ventable loss  due  to  operating  methods  as  per  Mr.  Louis 
Brandies  estimate?  Even  one  eighth  of  this  saving  in  opera- 
tion will  more  than  offset  all  possible  harm  done  by  less 
expensive  method  of  valuation. 

Let  us  take  now  for  another  illustration  a  power  plant  of  a 
Public  Utility  Company  of  25,000  kw.  capacity.     Its  value 
is  say  $2,500,000,  its  annual  output  160,000,000  kw.  hr. 
15  per  cent  fixed  charges  on  assessed  value  is  $375,000 
Operating  expense  @  .5c  per  kw.  hr.  is. . .  $800,000 

Suppose  that  error  was  made  in  valuation,  then,  if  its 
value  is: 

$3,000,000  its  fixed  charge  would  be $450,000 

$2,000,000  its  fixed  charge  would  be $300,000 

therefore  the  loss  to  either  company  or  to  the  pubUc  would 
be  $75,000. 

On  the  other  hand,  suppose  that  because  of  unstandard- 
ized  and  unscientific  methods  of  operation  of  this  plant  cost 
per  kw.  hr.  is  five  mills  whereas  it  could  and  should  cost  four 
mills.  This  spells  a  loss  to  the  community  paying  an  un- 
justly high  rate  for  power  and  light  or  to  the  company  losing 
its  margin  of  profit  more  than  it  would  be  if  the  valuation 
were  35  per  cent  in  error.  The  loss  to  the  company  from 
undervaluation  of  their  property  is  insignificant  in  compari- 
son to  actual  losses  due  to  lack  of  proper  operating  meth- 
ods. The  subject  of  correct  methods  of  evaluation  of  a 
property  is,  in  my  opinion,  completely  overshadowed  by  the 
importance  of  determining  of  the  proper  methods  of  use  of 
this  property. 

Ten  years  of  such  work  in  the  field  of  public  utihties  and 
central  station  management  did  not  show  me  a  single  case 
where  25  per  cent  of  operating  expenses  could  not  be  saved 
by  mere  changes  of  methods  without  a  penny  spent  for  better 
generating  equipment. 

What  is  needed  most  is  the  correct  valuation  of  operating 
and  managerial  methods  in  vogue,  and  the  danger  in  over- 
estimation  of  the  importance  of  valuation  of  property  is 
that  it  tries  to  trace  old  sins  instead  of  preventing  the  com- 
mitting of  new  ones. 


VALUATION      BY      APPROXIMATION 


191 


OPEN  DISCUSSION 


Dean  Langmuih,  Statistician,  Public  Service  Commission, 
New  York,  First  District: 

In  all  the  papers  and  discussions  concerning  valuation, 
nothing  has  been  said  about  the  effect  of  the  change  in 
the  value  of  the  dollar — ^and  yet  the  dollar  in  1906  is  said  to 
differ  in  value  by  one  half  from  the  dollar  of  ten  years  before. 
There  is  no  good  reason  why  this  should  be  overlooked. 
It  is  true,  as  Mr.  Whitten  said,  that  accounts  are  based 
strictly  on  numbers  of  dollars  and  that  they  never  indicate 
changes  in  the  value  of  money,  but  the  basis  of  accounting 
is  not  necessarily  significant. 

There  is  much  theorizing  as  to  the  methods  of  obtaining 
cost  to  reproduce  new  and  there  are  deep  researches  into  old 
records  to  determine  original  cost,  but  not  much  attention 
has  been  given  to  analyzing  and  understanding  the  nature 
of  the  difference  between  the  two  sets  of  values,  which 
probably  consists  largely  in  the  different  value  of  money. 
For  my  part,  I  think  that  ultimately  even  staunch  advocates 
of  original  cost  will  concede  that  original  cost  figures  should 
be  adjusted  for  the  changing  value  of  money  in  so  far  as 
this  is  due  to  a  mere  general  change  in  the  circulation  of 
gold.  Certainly,  if  corporations  fail  in  their  attempt  to 
secure  an  acceptance  of  the  cost  to  reproduce  new  theory, 
this  idea  will  become  of  ruling  importance  and  there  will 
be  a  strong  fight  to  adjust  on  account  of  the  monetary 
basis  of  original  cost  figures. 

If  it  is  desired  to  remove  the  element  of  speculation  as 
much  as  possible  from  public  utility  investment,  then  a 
return  should  be  based  on  the  economic  value  of  the  invest- 
ment rather  than  on  the  nominal  number  of  coins  contributed. 

F.  W.  Stevens,  General  Valuation  Counsel,  New  York  Cen- 
tral Lines,  New  York  City: 

Mr.  Cooke  in  his  remarks  made  a  statement  which,  so  far 
as  my  experience  goes,  cannot  be  true  at  times,  as  to  the 
attitude  towards  valuation  on  the  part  of  public  utility  men. 
With  such  little  experience  as  I  have  had  in  the  world,  I 
always  found  it  was  well  to  get  the  other  man's  point  of 
view — why  he  did  things.  We  are  pretty  much  ahke,  after 
all;  and  it  has  been  said  this  morning  that  if  we  were  in  the 
other  fellow's  situation  we  would  do  about  as  he  does,  as  a 
rule. 

Now,  the  Second  District  Commission  f of  the  State  of 
New  York,  as  you  know,  was  one  of  the  early  commissions; 
and  it  had  occasion  to  value  a  great  many  properties.  When 
the  commission  took  office,  precisely  the  feeling  which  Mr. 
Cooke  has  alluded  to  was  found — toward  commission  ap- 
praisals on  the  part  of  the  utiUties  men.  After  a  little 
experience,  the  public  utihties  of  the  Second  District  of 
New  York  were  entirely  willing  to  accept  the  valuations  and 
the  appraisals  of  the  commission,  without  putting  any  man 
on  it  at  all.  That  is  true  today.  I  have  just  asked  the 
chief  of  the  Division  of  Capitalization  if  he  knew  of  any 
exception  to  that,  and  he  said  he  did  not.  Why?  Because 
they  discovered  that  the  commission  adopted  the  course 


of  valuing  the  public  utihty  on  just  precisely  the  same 
principles  as  they  would  a  manufacturing  plant.  They 
treated  the  utility  on  precisely  the  same  principle  as  they 
would  anybody  else.  This  explains  a  part  of  it;  and  if  any- 
body will  adopt  that  principle  in  dealing  with  public  utilities 
I  claim  he  will  meet  with  the  same  results. 

There  is  another  thing:  the  valuation  that  is  going  on 
at  the  outset  excited  a  great  deal  of  quiet  distrust  among 
railroad  men.  They  didn't  know  how  they  were  going  to 
be  dealt  with.  And  yet,  after  the  valuation  had  been 
going  on  a  year  or  so,  I  have  heard,  with  very  trifling  excep- 
tion, a  unanimous  verdict  on  the  part  of  the  railroad  men: 
"We  are  being  treated  with  perfect  fairness."  Will,  or  will 
not,  that  change  the  attitude  of  the  public  utilities  men 
regarding  valuations? 

There  is  a  very  great  misapprehension  on  the  part  of 
many  as  to  the  attitude  of  the  railroads  regarding  the 
present  valuation.  I  have  had  a  considerable  experience  in 
the  matter,  and  I  have  yet  to  see  a  railroad  man  of  any 
standing  or  brains  who  was  worrying  about  the  question  of 
rates  at  all,  in  regard  to  this  valuation.  It  is  the  last  thing 
they  are  thinking  about.  There  may  be  some  down  along 
the  line;  I  have  not  seen  them  yet.  I  am  speaking  of  my 
own  experience. 

What  is  it  they  are  afraid  of?  The  great  systems  of  the 
country  foresee  and  know  that  in  the  next  ten  years  they 
must  put  into  railroad  construction  hundreds  of  millions  of 
dollars.  It  is  just  as  inevitable  as  it  is  that  the  earth  will 
turn  on  its  axis.  They  have  to  get  the  money  somewhere; 
and  they  have  to  preserve  their  credit.  That  is  what  they 
are  thinking  about.  They  see  that  next  year  they  have  to 
drop  in  twenty-five  millions  in  certain  places:  "How  are 
we  going  to  get  that  money?  Is  your  valuation  going  to 
destroy  our  credit  so  that  we  cannot  raise  the  money?" 

There  is  another  thing — I  simply  say  this  to  get  the 
attitude  of  what  I  know  to  be  the  railroad  men  before  your 
minds:  there  is  another  thing  that  faces  the  men  who  represent 
the  railroads  that  I  don't  think  is  fully  appreciated  by  those 
who  represent  the  public,  exactly,  and  I  wish  you  to  look  at 
it.  Sometimes  you  may  think  that  they  are  a  Uttle  bit 
insistent  on  details;  and  the  case  that  Mr.  Cooke  mentioned, 
of  course,  was  a  ridiculous  absurdity — no  man  of  broad 
mind  has  ever  done  any  such  thing  as  that.  But  what  is 
one  to  do?  I  am  representing  a  railroad  system.  In  this 
valuation,  a  cent  on  a  tie  is  a  pretty  insignificant  sum;  and 
any  man  who  will  stand  and  quarrel  about  a  cent  on  a  tie 
is  a  pretty  small-potato  fellow.  But  on  the  system  which 
I  represent,  a  cent  on  a  tie  represents  a  half-million  dollars. 
What  am  I  to  do?  There  is  a  problem  I  am  up  against, 
among  others.  If  I  was  charged  with  a  lawsuit  of  half  a 
million  dollars  by  the  railroad  systems  which  I  am  now 
representing,  it  would  be  thought  an  important  matter. 
Should  I  throw  it  away  on  a  cent  on  a  tie,  more  than  in  other 
ways? 


192 


THE      UTILITIES      MAGAZINE 


John  G.  Morse,  Appraiser,  Associated  Factory  Mutual  Fire 
Insurance  Companies: 

"I  would  haggle  over  a  cent  in  the  price  of  a  tie,  but 
having  determined  the  exact  value  of  a  tie,  I  would  not 
bother  to  count  them.  I  would  ascertain  the  average  num- 
ber of  ties  per  mile  of  track  and  multiply  that  by  the  num- 
ber of  miles  of  railroad. 

RoBEKT  L.  Hale,  Lecturer  in  Economics,  Columbia  Uni- 
versity: 

The  discussion  this  afternoon  seems  to  have  been  directed 
solely  to  ascertaining  the  value  of  plants.  Yet  if  plants  are 
always  to  be  permitted  to  earn  a  return  on  their  value,  it 
was  quite  clearly  demonstrated  last  night  and  this  morning 
that  you  can  never  reduce  earnings.  It  is  only  if  you  are 
basing  earnings  on  something  other  than  value  that  there  can 
be  any  occasion  for  making  a  so-called  "valuation"  for  rate 
making  purposes  at  all. 

It  may  be,  however,  that  an  inventory  of  the  value  of  the 
different  parts  of  a  plant  will  throw  light  on  the  actual  cost. 
Such  a  method  is  expensive  and  inaccurate,  as  Mr.  Stevens 
and  others  have  pointed  out.     Is  it  absolutely  essential.'' 

As  far  as  future  investments  are  concerned,  it  would  be 
quite  feasible  for  the  commission  to  have  accurate  knowledge 
of  the  actual  cost,  without  the  use  of  inventories,  by  means 


of  accounting  requirements  and,  perhaps,  through  control  of 
capitalization.  If  we  should  begin  at  once  to  keep  track 
of  future  investments  in  this  way,  the  only  possible  use  of 
an  inventory  for  rate  making  would  be  to  ascertain  the  cost 
of  investments  made  prior  to  now. 

Is  it  important  to  ascertain  the  cost  of  past  investments, 
provided  we  keep  track  of  the  cost  of  all  future  ones  and  of 
additions  to  past  ones?  .  If  the  past  returns  have  been 
excessive,  so  that  the  stick  has  been  sold  at  a  price  above 
actual  cost,  it  is  rather  hard  to  deprive  the  buyers  at  the 
advanced  price  of  part  of  their  value,  without  warning. 
On  the  other  hand,  it  is  hard  to  compel  comsumers  to  pay 
more  than  a  return  on  actual  cost  merely  because  they  had 
been  compelled  to  pay  more  in  the  past.  There  is  no 
satisfactory  escape  from  this  dilemma  in  dealing  with  the 
past  situation.  Any  figure  we  adopt  for  past  investments 
will  be  arbitrary,  and  while  it  may  be  worth  while  to  have 
some  sort  of  idea  of  how  much  the  market  value  exceeds 
actual  cost,  or  whether  it  exceeds  it  at  all,  still  we  have  no 
need  for  very  accurate  figures.  Inventories  may  be  the 
best  way  of  getting  even  a  rough  idea.  There  is  need  for 
adopting  at  once  some  figure,  however,  for  existing  plants, 
whether  with  or  without  the  help  of  inventories.  When 
such  figures  are  once  obtained,  there  will  be  no  further 
occasion  for  inventories,  provided  we  deal  with  the  future 
on  the  basis  of  allowing  a  fair  return  on  actual  cost. 


EXPERT  (OR  OPINION)  TESTIMONY  IN   RATE   VALUATION   CASES 

A  STUDY  IN  THE  ADMINISTRATION  OF  JUSTICE 

By  John  H.  Gray 

Professor  of  Economics,  University  of  Minnesota 


INTRODUCTION 

THE  economic  environment  of  man  changes  much 
more  rapidly  than  his  understanding  of  it. 
That  is,  the  environment  actually  changes  long 
before  we  appreciate  the  fact  of  change  or  acquire  any 
philosophy  of  it,  or  any  means  of  adjusting  the  laws 
and  institutions  to  it.  This  means  that  the  rights 
and  duties  of  different  individuals,  or  groups,  are 
adjusted  at  any  one  time  to  a  condition  of  affairs 
that  has  already  passed  away.  Hence,  social  unrest 
and  agitation.  There  are  certain  reasons  why  such 
changes  in  this  country,  in  our  day,  have  been  much 
more  rapid  than  at  any  other  time  or  place.  The 
extent,  richness  and  variety  of  our  material  resources 
in  connection  with  the  vigor  and  virility  of  our  popula- 
tion have  offered  an  unparalleled  rate  of  change  in  this 
country.  At  the  same  time,  the  isolation  of  our  coun- 
try until  recently,  the  absence  of  military  invasion 
for  more  than  one  hundred  years,  and  the  lack  of  a 
strong  central  government,  have  further  intensified 
these  conditions. 


Justice  Holmes  spoke  truly  when  he  said  that  the 
degree  of  social  peace  and  happiness  in  any  country,  at 
any  time,  depends  on  the  width  of  the  gap  between 
actual  conditions  and  the  institutions,  rules  and  govern- 
ment arrangements  for  dealing  with  these  conditions. 
The  laissez-faire  doctrine,  with  its  worship  of  competi- 
tion came  into  vogue  at  the  advent  of  the  industrial 
revolution.  Under  the  circumstances  just  mentioned, 
this  doctrine  gave  the  greatest  opportunity  in  this 
country  that  the  world  has  yet  seen  for  accumulation 
and  combination  of  vast  masses  of  capital.  This 
results  in  a  higher  degree  of  monopoly  than  is  to  be 
found  elsewhere.  The  cause  of  American  preeminence 
in  this  regard  is  the  wide  use  of  machinery  and  the 
most  perfect  means  of  diffusing  information  and  trans- 
ferring commodities  ever  created.  These  forces  are 
cumulative  and  self-accelerative. 

While  competition  has  not  entirely  disappeared  from 
our  economic  life,  we  find  ourselves,  today,  in  the  midst 
of  an  economic  era  characterized  by  monopoly.  The 
field  of  public  utilities,  including  common  carriers,  is 


OPINION      TESTIMONY 


193 


the  most  significant  and  important  phase  of  the  gigantic 
problem  of  monopoly.  This  whole  important  group 
of  industries  finds  absolutely  no  place  in  the  social 
and  political  philosophies  that  have  dominated  the 
English-speaking  world  for  more  than  a  century;  and 
as  yet,  in  the  hurly-burly  of  an  age  of  wealth  and  spec- 
ulation, we  find  ourselves,  at  the  beginning  of  the 
twentieth  century,  with  this  problem  of  problems  on 
our  hands  and  without  a  theory,  or  philosophy,  or 
plan,  or  helpful  traditions,  or  instincts,  suitable  for 
dealing  with  it.  We  have  attacked  it  piecemeal  and 
spasmodically  in  a  haphazard  way,  only.  We  shall 
make  no  important  step  towards  the  solution  of  the 
problem  until  we  realize  once  for  all  that  it  is  a  new 
and  separate  and  distinct  thing, 
which  at  present  has  no  place 
and  can  find  no  place  in  the 
philosophy  or  institutions  cre- 
ated to  deal  with  an  entirely 
different  and  simpler  environ- 
ment —  an  environment,  too, 
in  which  the  doctrines  of  com- 
petition, individual  liberty  and 
freedom  of  contract,  coupled 
with  unlimited  right  of  specu- 
lation, are  the  cornerstones  of 
the  system. 


REGULATE   BECAUSE  OF 
MONOPLY 


PART  XI 


OPINION  TESTIMONY 


monopolistic  industries.  In  non-monopolistic  indus- 
tries, competition  is  a  regulator  of  price,  and  a  safe- 
guard of  the  consumer.  In  monopolistic  industries 
there  is  no  natural  force  to  regulate  prices  and  hence 
none  such  to  protect  the  consumer.  The  diflBculties, 
at  this  point,  are  greatly  increased  where,  as  in  the 
case  under  consideration,  the  industry  is  one  of  increas- 
ing returns.  For  this  fact  alone  makes  attempted 
competition  unequal  and  totally  destructive;  when  the 
destruction  is  complete,  monopoly  inevitably  follows. 
Hence,  in  the  case  of  monopoly  in  private  hands,  we 
must  either  leave  interested  and  greedy  men  to  be 
economically  judges  in  their  own  cases,  or  we  must 
set  up  an  eflFective  outside  agency  to  regulate  them. 

But  it  is  no  safer  in  economics 
than  in  law  to  make  a  man 
judge  in  his  own  case.  Presi- 
dent Taf t  has  said :  * 


The  problem  of  monopoly  is 
the  problem  of  democracy  and 
the  heart  of  the  problem  is  the 
public  utility.  Upon  the  deal- 
ing with  this  question  in  Am- 
erica will  depend  the  fate  of  modern  civilization. 

For  something  like  a  generation  now,  we  have  de- 
clared the  industries  under  observation  to  be  public 
service  industries  and,  therefore,  to  be  subject  to  a  kind 
and  a  degree  of  public  regulation  from  which  private 
property  is  exempt.  It  is,  perhaps,  unnecessary  to 
state  that  the  distinction  is  purely  a  legal,  not  an 
economic  one.  We  call  these  public  utilities  or  public 
service  industries  simply  because  we  think  they  ought 
to  be  subject  to  this  higher  degree  of  regulation.  But 
what  is  there  in  the  nature  of  these  industries  them- 
selves that  requires  severer  regulation?  The  answer 
is  easy.  It  is  the  fact  that  they  are  monopolies.  But 
this  is  a  purely  economic,  not  a  legal,  distinction.  Fur- 
thermore, for  the  last  three  hundred  years,  no  English- 
speaking  community  has  required  evidence  to  prove 
that  unregulated,  private  monopoly  in  important  mat- 
ters is  intolerable  and  destructive  of  civilization. 
Let  us,  for  a  moment,  contrast  monopolistic  and  non- 
13 


'  When  we  come  to  expert  testimony  we  find,  first 
an  unwillingness  on  the  part  of  the  great  majority 
of  men  of  ability  to  take  employment  on  any  terms 
on  behalf  of  the  public.  There  is  great  danger  that 
to  do  so  will  destroy  his  professional  career.  He 
becomes,  in  the  language  of  the  day  and  in  the 
opinions  of  the  vested  interests,  unsafe. 

If  we  bear  in  mind  what  1  have  said  about  the 
abuses  of  expert  testimony,  the  cumbering  and 
lengthening  of  records,  the  protracting  of  trials,  and 
the  expense,  we  can  readily  see  that,  speaking 
practically  not  technically,  justice  is  actually  denied 
in  the  vast  majority  of  cases  before  the  cases  come 
to  final  adjudication  by  the  Supreme  Court  of  the 
United  States.  Truly  in  this  field,  if  ever,  justice 
delayed  is  justice  denied." 


"  The  judge  who  presides  over 
a  cause  in  which  he  is  interested 
dies  in  infamy  if  he  is  discovered. 
The  citizen  who  constitutes  him- 
self judge  in  his  own  cause  as 
against  his  fellow  citizen,  and  pre- 
sumes to  attack  him  is  a  law 
breaker  and  as  such,  disgraced." 

It  is  by  this  route  that  we 
arrive  at  the  necessity  of  regu- 
lating public  utilities.  Recur- 
ring then  to  the  legal,  not  the 
economic  side,  we  have  declared 
through  the  courts  that  the  util- 
ity is  entitled  to  a  fair  rate  of 

. I     income  on  the  fair  value  of  the 

property.  The  judges  of  our 
courts  are  not  economists.  The  whole  doctrine  of 
regulation  grew  out  of  the  instinctive  fear  of  monopoly. 
But  if  the  judges  had  been  economists  they  would  long 
ago  have  recognized  that  this  doctrine  of  fair  value, 
although  it  came  from  the  fear  of  monopoly,  is  abso- 
lutely inconsistent  with  the  fact  of  monopoly  and  with 
the  public  interest  with  which  the  law  clothes  these 
properties.     Let  us  look  at  this  point  a  little  closer. 

NO  SPECULATIVE  GAINS  FOR  MONOPOLIES 

The  essence  of  private  property  is  that  the  owner 
is  held  in  check  by  competition  to  such  a  degree  that 
it  is  safe  to  allow  him  the  increased  value  that  comes 
to  his  property  from  social  progress  or  otherwise;  and 
that  if  incidental  harm  comes  from  this  speculative 
increase  in  value,  such  harm,  on  the  average,  is  offset 
by  the  added  energy,  effort  and  thrift  caused  by  the 

'  Cited  in,  Carnegie  Endowment  for  International  Peace,  Year  Book,  1916, 

p.  2. 


194 


THE      UTILITIES      MAGAZINE 


opportunity  for  speculative  gains.  But  the  moment 
we  begin  to  try  to  control  the  utilities  because  they 
are  monopolies,  that  moment,  if  we  are  consistent, 
we  must  see  that  the  speculative  element  is  the  key  to 
the  situation;  that  in  a  public  utility  it  is  unthinkable 
that  the  private  owner  should  hope  for,  expect,  or 
receive,  any  speculative  gains  whatever.  He  is  eco- 
nomically entitled  to  a  fair  compensation  for  his  con- 
tribution to  the  enterprise  only  and  cannot,  therefore, 
economically  be  allowed  the  speculative  gains  included 
in  a  fair  value.  To  allow  him  this  legally  is  in  fact 
to  knock  the  very  foundation  from  under  the  legal 
doctrine  and  basis  of  regulation.  If  he  may  have  the 
speculative  value  coming  from  the  increase  of  land 
values,  in  the  great  terminals,  and  from  social  progress, 
he  is  no  longer  rendering  a  public  service,  but  engaged 
in  private  speculation  in  urban  real  estate.  Nor  is  he 
longer  rendering  a  service  for  a  fair  return.  The  return 
is  no  longer  a  fair  one  for  his  services,  but  is  dependent 
on  the  success  of  private  speculation.  Economically 
speaking,  the  undertaking  is  no  longer  what  the  law 
calls  it,  a  public  utility,  for  it  has  by  this  ruling  been 
reendowed  with  all  the  essential  attributes  of  private 
property  and  the  statement  that  it  is  a  public  utility 
is  a  meaningless  legal  technicality.  A  fair  value,  under 
such  circumstances,  has  no  relation  whatever  to  any 
contribution  or  sacrifice  the  private  owner  has  made, 
or  to  any  service  he  has  rendered,  or  is  required  to 
render,  or  is  ever  likely  to  render.  Is  it  not  a  strange 
circumstance  that,  forced  by  the  mistakes  of  the  courts 
in  America,  we  should  be  pursuing  this  will-o'-the-wisp 
in  regard  to  these  great  arteries  of  our  social  and  indus- 
trial life — the  instruments  on  which  our  very  common 
life  and  civilization  depend — at  the  very  time  when 
all  the  rest  of  the  civilized  world  is  moving  so  rapidly 
to  the  conclusion  that  urban  land  not  used  for  these 
(legally)  public  utilities  can  no  longer  be  left  to  unlim- 
ited private  speculation?  For  the  world,  everywhere, 
except  in  America,  is  fast  realizing  that,  by  allowing 
this  private  speculation  in  land,  we  have  brought  it 
about  that  no  city  of  considerable  size  is  a  fit  place  for 
human  habitation.  Yet,  in  law,  we  proclaim  the 
industries  under  consideration  public,  and  that  their 
private  owners  are  entitled  to  a  fair  return  only  on  the 
fair  value.  Legally,  therefore,  the  utilities  are  entitled 
to  a  fair  rate  on  the  present  speculative  value.  But  to 
allow  them  this  is  entirely  inconsistent  with  the  chief 
economic  reasons  calling  for  any  regulation.  In  fact, 
we  took  them  out  of  the  category  of  private  industries 
and  subjected  them  to  a  special  regulation  in  the  public 
interest  to  avoid  this  very  element  of  speculative  gains 
included  in  fair  value.  In  other  words,  we  regulate 
them  solely  because  they  are  monopolies.  But  our 
doctrine  of  regulation  gives   them  all  the  essential 


elements  of  private  property,  with  the  speculative 
gains  belonging  to  private  and  non-monopolistic  indus- 
tries added  thereunto. 

Nor  must  we  conclude  that  this  is  merely  a  theoretical 
consideration  of  no  practical  moment.  One  of  the 
chief  organs  '  of  vested  interests  in  a  recent  issue 
predicts  that  the  unearned  increment  on  the  terminals 
of  the  New  Haven  Railroad  would  more  than  offset 
the  loss  caused  by  a  forced  judicial  sale  of  the  whole 
system,  should  that  be  brought  about.  The  same 
journal  estimates  that,  taking  the  railroads  of  the 
country  as  a  whole,  from  30  to  40  per  cent  of  the  value 
is  in  land  and  that  this  land  is  probably  worth  today 
$600,000,000. 

SPECULATIVE  GAINS  ANNUAL  REGULATION 

The  current  valuation  of  the  railroads  by  the  Inter- 
state Commerce  Commission  may  be  of  practical  sig- 
nificance in  helping  us  to  determine  how  much  is  due 
the  public  utilities  as  a  result  of  their  past  speculation, 
but  can  have  no  importance,  whatever,  as  an  aid  to 
future  rate  regulation.  For  we  are  dealing  with  a 
monopoly  and  everybody  knows  that  value  in  the  case 
of  a  monopoly  in  a  vitally  necessary  service  depends 
upon  demand  at  present  rates  and  that  the  value  goes 
up  with  the  increased  effective  demand  for  the  service. 
That  is,  increased  earnings  give  increased  value  with- 
out limit.  Incidentally,  it  may  be  remarked  that  in  a 
growing  community,  ordinarily  no  increase  of  rates 
is  necessary  to  bring  about  this  increased  value,  but  a 
mere  allowing  the  company  to  take  up  the  slack  from 
social  growth.  If,  therefore,  increased  value  is  a  justi- 
fication for  increased  rates,  in  industries  as  necessary 
as  these  are,  all  the  utility  has  to  do  is  to  wait  for  social 
growth  and  the  consequent  increase  in  demand.  The 
regulator  of  value,  under  such  circumstances,  is  the 
need  of  the  people  for  the  service  accompanied  by 
ability  and  willingness  to  pay  the  price  rather  than 
go  without  the  service.  This  brings  us  back  squarely 
to  rates  based,  not  on  regulation  as  a  fair  return,  but 
on  what  the  traflfic  will  bear.  Under  this  theory,  car- 
ried to  its  logical  conclusion,  regulating  commissions 
have  nothing  left  to  do  but  to  check  discrimination. 
Even  the  regulation  of  service,  where  such  regulation 
lessens  profits,  is  not  possible  under  the  doctrine  of 
fair  value. 

To  all  those  who  have  followed  the  representations  of 
the  railroads  before  the  Valuation  Board,  it  is  very 
plain  that  the  raUroads  are  massing  all  their  combined 
resources,  financial  and  intellectual,  to  get  the  Inter- 
state Commerce  Commission  to  adopt  the  doctrine 
that  the  "fair  value"  of  Smythe  vs.  Ames  means  ordi- 
nary commercial  or  exchange  value. 

»  WaU  Street  Journal,  Oct.  28,  1915. 


OPINION      TESTIMONY 


195 


I  have  chosen  the  subject  of  Expert  or  (Opinion) 
Testimony  in  Valuations  for  Rate  Making  purposes 
merely  in  order  to  point  out  some  changes  in  our  theory 
and  methods  of  valuation  which  I  consider  necessary 
if  we  are  to  serve  and  not  to  injure  the  public  by  regu- 
lation. 

Smythe  vs.  Ames,  1898,  naturally  opened  the  way 
for  making  valuation  the  basis  of  rate  regulation. 
The  move  for  valuation  originated  in  the  attempt  to 
prevent  the  companies  from  claiming  rates  to  pay 
dividends  on  watered  stock.  Whether  this  was  brought 
to  its  present  dominant  influence  primarily,  as  a  result 
of  some  unwise  rulings  by  the  courts,  or  whether  it 
was  forced  upon  the  world  by  some  outside  party,  I 
have  been  unable  to  learn.* 

RULES   OF  EVIDENCE   HISTORICALLY 
CONSIDERED 

I  shall  deal  primarily  with  expert  testimony  before 
commissions,  but  in  order  to  keep  our  bearings  on  this 
subject  we  must  remember  that,  under  our  constitu- 
tional system  with  its  separation  of  powers  and  suprem- 
acy of  courts,  the  commissions  are  so  thoroughly 
subject  to  the  courts^  that  we  may  properly  regard  com- 
missions very  much  in  the  same  class  as  masters  in 
chancery  or  as  court  commissioners,  namely,  as  mere 
helpers  or  assistants  of  the  courts.  This  fact  necessi- 
tates a  summary  of  the  development  of  our  law  with 
special  reference  to  the  rules  of  evidence  and  methods 
of  proof  in  different  branches  of  the  law. 

JUDGE  (COMMISSION),  JURY  AND  WITNESS 

It  is  generally  known  that  the  strict  rules  of  evidence, 
as  they  exist  today,  are,  for  the  most  part,  the  creation 
of  the  last  century.  And  that  one  of  the  most  impor- 
tant rules,  so  far  as  our  present  purpose  is  concerned, 
is  that  in  ordinary  judicial  matters  a  lay  witness  must 
confine  his  testimony  to  matters  of  knowledge  (for  the 
most  part  to  facts  perceived  by  the  senses,  that  is, 
experiential  knowledge)  and  must  not  indulge  in  opin- 

•  So  far  as  my  information  goes.  Prof.  John  R.  Commons  was  the  first  to 
throw  the  weight  of  his  great  influence  in  favor  of  making  valuation  the 
cornerstone  of  all  regulation.  Whether  the  idea  was  original  with  him  or 
came  from  Senator  LaFoUette,  who  afterwards  put  tlirough  the  bill  for  the 
valuation  of  the  railroads,  I  do  not  know. 

*  Hammond,  J.  Fall  Rirer  Gas  Works  Co.  vs.  Board  of  Gas  &  Eleclrk  Light 
Commissioners,  214  Mass.  259,  May  23,  1913.  "But  in  acting  upon  an 
application  (for  stock  issue)  the  Board  (Commission)  is  engaged  in  the  per- 
formance of  a  quasi-judicial  function  and  should  be  moved  only  by  considera- 
tions logical  to  the  issue  and  not  inconsistent  with  the  rights  of  parties. 
.  .  .  The  general  question  as  to  the  necessity  of  the  issue  for  the  pur- 
poses for  which  it  was  lawfully  authorized,  was  the  same  and  should  be  de- 
cided upon  the  same  considerations,  whether  decided  in  the  first  case  by  the 
corporation  itself  (and  if  need  be  by  the  court  afterwards)  or  by  the  Board. 
There  b  no  change  in  the  question  nor  of  the  principles  upon  which  it  is  to  be 
decided.  The  only  change  is  in  the  party  deciding  it."  Cf.  Judge  McPher- 
son  in  Des  Moines  Gas  Case,  199  Fed.  204. 


ions,  inferences,  or  judgments  based  on  facts  in  evi- 
dence in  the  case:  the  theory  being  that  the  jury  is  the 
judge  of  the  facts  in  the  case  as  the  judge  is  of  the  law. 

But  we  should  remember  that  this  function  of  the 
jury  is  itself  a  creature  of  the  recent  separation  of 
functions  between  judge,  jury  and  witnesses.  Until 
probably  about  1700  the  jury  was  not  confined  wholly 
to  the  testimony  of  witnesses  but  picked  up  all  the  in- 
formation it  could,  directly  and  indirectly.  The  jurors 
were  from  the  neighborhood  and  were  supposed  to  have 
first-hand  personal  knowledge  of  the  case.  It  appears 
that  the  members  of  the  jury  from  about  1500  to 
1600,  or  later,  were,  from  the  standpoint  of  present 
functions,  as  much  witnesses  as  jurors.  "The  Jury 
were  a  mere  body  of  triers  helping  the  court."  Lord 
Hale  (1680)  brought  this  out  in  contrasting  the  common 
law  with  the  civil  law  and  the  canon  law,  saying,  "for 
the  trial  is  not  here  by  witnesses  but  by  jury."^ 

Holt,  Lord  Chief  Justice,  somewhat  later,  in  speak- 
ing of  this  double  function  of  the  jury  said,  "Therefore 
less  evidence  is  required  than  in  the  civil  law."  About 
the  same  time  Dr.  Oldish  said,  "Because  the  jury  are 
witnesses  in  reality  according  to  the  laws  of  England 
being  presumed  to  be  ex  viceneto."* 

After  1500  the  common  law  courts  came  more  and 
more  to  depend  on  witnesses  and  it  became  necessary 
to  lay  down  more  strict  rules  of  evidence  and  neces- 
sarily to  differentiate  more  and  more  the  functions  of 
judge,  jury,  and  witnesses.  The  change  had  taken 
pretty  definite  form  by  1600.  But  the  strictness  of 
the  rules  of  evidence  were  of  much  later  growth. 

Coke,  1622,  said,'  "It  is  no  satisfaction  for  a  witness 
to  say  that  'he  thinketh'  or  'persuadeth  himself  and 
that  for  two  reasons:  first,  because  the  judge  is  to  give 
an  absolute  sentence,  and  for  this  ought  to  have  a  more 
sure  ground  than  'thinking,'  secondly,  the  witness 
cannot  be  sued  for  'perjury.'"  (Let  us  remember  this 
last  reason  when  we  come  to  deal  with  expert  testimony.) 
He  added,  "We  want  what  you  know,  not  what  you 
think  or  believe."  That  is,  the  court  felt  that  it  could 
guess  as  well  as  a  witness  could.  This  was  said  of  lay 
witnesses,  but  has  its  bearing  on  expert  testimony  as 
developed  later. 

It  may  be  safely  concluded,  therefore,  that  so  soon 
as  the  function  of  the  witness  was  clearly  differentiated 
from  that  of  the  jury  the  first  essential  of  competency 
was  that  the  witness  should  have  knowledge  (experi- 
ential knowledge)  and  should  testify  to  facts  only,  and 
leave  the  inferences  and  interpretations  to  the  jury. 
The  later  modification  of  this  rule  is  that  lay  witnesses 
may  give  their  opinions,  or  judgment,  where  they  are 

'  History  of  the  Common  Law,  Chap.  12. 

'  Cited  by  Wigmore,  Harvard  Law  Review,  XV,  p.  96. 

'  Adams  vs.  Canon,  cited  by  Wigmore,  Evidence,  §  1917. 


196 


THE      UTILITIES      MAGAZINE 


otherwise  competent  witnesses  from  having  had  an 
opportunity  to  observe  and  experience  pertinent  facts, 
in  those  cases  where  the  facts  on  which  these  judg- 
ments or  opinions  are  based  are  of  such  a  nature  as  to 
make  it  impossible  to  present  them  to  the  jury  in  such 
a  way  that  the  jury  can  understand  them. 

VALUE  AND  OPINION  TESTIMONY 

Value  was  usually  regarded  as^  an]  exception '  to  the 
opinion  rule  until  recently  (except  in  New  Hampshire 
and  New  York),  but  the  tendency  was  to  depend  on 
non-skilled  witnesses  and  not  to  require  experience  in 
dealing  in  real  estate  (which  was  the  chief  object  of 
valuations)  as  a  qualification. 

The  need  of  expert  witnesses  has  greatly  increased  in 
the  last  century  due  to  the  increasing  complexity  of  the 
world,  caused  by  the  birth  of  modern  science  and  the 
industrial  revolution.  The  difficulty  is  to  provide  a 
place  for  such  witnesses  under  a  system  of  jurisprudence 
which  insisted  for  centuries  that  witnesses  should  testify 
to  facts  and  not  to  opinions.  Confining  ourselves  for 
the  moment  to  jury  trials,  it  was  admitted  that  the  jiu-y 
needed  such  help,^  and  that  such  witnesses  did  not  come 
under  the  fact  rule.  They  were  regarded  as  strictly 
an  exception. 

LORD  MANSFIELD  ADMITTED  REAL 
EXPERTS  ONLY 

Although  experts  had  previously  been  heard  in  rare 
cases,^  largely  on  purely  technical  points  and  as  advisers 
to  the  court,  the  opinion  rule  began  to  take  definite 
shape  under  Lord  Mansfield,  about  the  middle  of  the 
eighteenth  century,'  who  attempted  to  show  that  in 
matters  of  science  such  testimony  had  such  a  flavor  of 
fact  about  it  as  to  justify  it.  In  short,  he  considered 
it  matter  of  facts,  but  of  such  facts  as  only  an  expert,  a 
man  scientifically  trained  in  this  particular  science, 
could  understand. 

The  particular  question  was  that  of  the  cause  of  the 
filling  up  of  a  harbor  and  the  expert  was  an  engineer,  by 
whom  called  does  not  appear.  Lord  Mansfield  said,'' 
"I  cannot  believe  that  where  the  question  is  whether  a 
defect  arises  from  a  natural  or  an  artificial  cause,  the 
opinions  of  men  of  science  are  not  to  be  received. 

The  cause  of  the  decay  of  the  harbor  is  also  a  matter 

of  science Of  this  such  men  as  Mr.  Smeaton 

alone  can  judge.  Therefore  we  are  of  opinion  that  his 
judgment  formed  on  facts,  was  very  proper  evidence." 

'  Wigmore,  Evidence,  §  1943. 

'Wigmore,  Evidence,  §1917. 

'  Judge  Hand,  Harvard  Law  Rev.  15,  p.  44,  says  the  earliest  case  of  real 
expert  testimony  he  has  been  able  to  find  was  that  of  Alaop  vs.  BowtreU, 
1620. 

*  Polices  vs.  Chadd,  cited  by  Wigmore,  Evidence,  §1917. 


By  1800,  men  of  science  were  generally  permitted  by 
way  of  exception  to  give  opinion  testimony.  "Though 
witnesses  can  in  general  speak  only  as  to  facts,  yet  in 
questions  of  science  persons  versed  in  the  subject  may 
deliver  their  opinion  upon  oath  on  the  case  proved  by 
other  witnesses."  '  It  will  be  observed  from  this  that 
in  the  beginning  when  an  expert  was  allowed  to  express 
opinions  it  was  on  facts  presented  to  the  court  by  lay 
witnesses.  How  different  this  from  the  present  utility 
witnesses  overwhelming  the  court  with  new  theories  of 
their  own. 

"At  the  beginning,  therefore,  such  testimony  was 
considered  as  a  distinct  exception  to  the  general  rules  of 
evidence  and  the  emphasis  was  placed  on  the  fact  that 
the  opinion  of  experts  must  be  based  on  the  facts  pre- 
sented by  other,  or  lay,  witnesses"  «  and  the  facts  in  the 
particular  case.'' 

Dean  Wigmore  attempts  to  draw  a  hard  and  sharp 
line  between  mere  opinion  of  (lay)  witnesses  and  opinion 
based  on  facts  within  the  knowledge  of  the  witness  him- 
self, and  ascribes  the  early  American  hostihty  to  opinion 
testimony  in  general  to  a  misinterpretation  of  Lord 
Mansfield's  dictum  in  Carter  vs.  Boehm  (1766)  that, 
"mere  opinion  is  not  evidence"  to  mean  that  "opinion 
is  not  evidence."  * 

Chief  Justice  Gibbs  (1816)*  after  saying  that  Lord 
Mansfield  and  Lord  Kenyon  discountenanced  this  evi- 
dence of  opinion,  said,  "  It  is  not  a  question  of  science, 
in  which  scientific  men  will  mostly  think  alike,  but  a 
question  of  opinion,  liable  to  be  governed  by  fancy,  and 
in  which  the  diversity  might  be  endless.  Such  evidence 
leads  to  nothing  satisfactory  and  on  that  ground  ought 
to  be  rejected."  Is  the  modem  utility  expert  testi- 
mony governed  by  fancy  and  is  the  diversity  endless? 

As  late  as  1838  Justice  Coleridge,  in  discussing  the 
admissibility  of  opinion  testimony,  said,'  "Where  you 
can  bring  the  decision  of  that  question,  as  you  some- 
times may,  to  depend  upon  deductions  from  scientific 
premises  you  may  hear  those  deductions  expressed  as 
opinions  by  scientific  men.  The  necessity  of  the  case 
justifies  this  departure  from  the  general  rule;  but  com- 
petency in  the  main  is  a  question  of  fact,  and  the  jury 
are  to  draw  their  conclusions  from  the  evidence  from 
the  facts  before  them,  not  from  the  opinions  which 
others  may  have  formed  from  facts  not  before  them." 
He  adds  that  while  inferences  by  fact  witnesses  are  in 

'  T.  Peake  (1801)  cited  in  Wigmore,  Evidence,  §1917.  Cf.  I  Espinasse, 
Nisi  Priua.    N.P.  1st  Amer.  Ed.  to  same  effect  (1801). 

«  Cited  by  Wigmore,  Evidence,  §1917. 

'  "Of  testimony  on  value,  Wigmore,  Evidence,  §715,  says  "knowledge 
must  be  of  value  in  the  vicinity."  Is  this  true  of  expert  testimony  in  rate 
cases  today? 

1  IHd.  §1917. 

»  Wright  vs.  Tatham,  5  CI.  &  F.  690.     Cited  in  Wigmore,  Evidence,  §1917. 

See  duo  Carter  vs.  Boehm  (1766) "We  all  think  the  jury 

ought  not  pay  the  least  regard  to  it." 


OPINION      TESTIMONY 


197 


practice  admitted,  "I  am  not,  however,  aware  that  the 
question  has  ever,  upon  argument,  been  decided  to  be 
correct  in  form."  We  may  conclude,  then,  that  until 
about  a  century  ago,  the  general  rule,  with  the  excep- 
tions already  noted,  excluded  opinion  testimony.  In 
1824,  the  general  rule  was  stated'  as  follows:  "The 
.  general  distinction  is  this,  that  the  jury  must  judge  of 
the  facts  for  themselves."  So  far  as  experts  had  been 
used,  by  way  of  exception,  they  had  been  confined 
largely  to  questions  involving  handwriting,  insanity, 
and  maritime  aflfairs.  The  American  courts  even 
excluded  opinions  by  fact  witnesses.  The  problem  did 
not  become  one  of  the  first  magnitude  practically  until 
the  last  generation  when  we  began  to  try  to  regulate 
public  utility  rates. 

WITNESSES    WITH    PECUNIARY    INTEREST 
EXCLUDED 

There  is  another  phase  of  the  law  of  evidence  which 
at  first  blush  seems  remote  from  our  subject,  but  which, 
in  view  of  recent  developments  in  American  valuations 
becomes  pertinent.  It  is  well  known  that,  until  about 
the  middle  of  the  nineteenth  century,  in  both  England 
and  America,  no  party  with  a  pecuniary  interest  in  a 
case  was  admissible  as  a  witness  under  any  circum- 
stances. There  is  no  doubt  that  the  application  of 
this  rule  in  many  instances  caused  miscarriage  of  justice 
and  that  it  prevented  the  bringing  of  many  just  causes 
into  court. 

The  rule  was  abolished  in  1843  in  England  and  began 
to  disappear  very  slowly  in  the  various  American  states 
a  little  later.  The  great  argument  for  the  abolition  was 
put  forth  by  Jeremy  Bentham  ^  in  1827.  The  bench 
and  bar  of  both  countries  long  opposed  the  change  of  the 
rule  in  this,  as  in  the  case  of  all  other  changes.  After 
the  exclusion  rule  had  been  abolished  they  universally 
lauded  the  change,'  and  declared  it  one  of  the  greatest 
reforms  ever  instituted  in  the  law. 

In  view  of  the  recent  testimony  of  the  defendants  in 
personal  damage  cases*  against  public  utilities  and  of 
expert  testimony  in  valuation  cases  it  may  well  be 
questioned  whether  we  do  not  have  here  the  oft-recur- 
ring example  of  a  change  in  legislation,  or  other  rules, 
that  gives  results  very  different  from  those  anticipated. 

But  some  one  may  say  that,  so  far,  my  argument  is 
beside  the  point,  because  the  public  utility  cases  so  far 
as  our  present  discussion  is  concerned  are  not  jury 

'  Starkie  Evidence,  cited  by  Wigmore,  Evidence,  §1917. 

'  The  Rationale  of  Judicial  Evidence,  Book  IX.     Pt.  Ill,  C.  III. 

'  See  Wigmore,  Evidence,  §  576  for  list  of  authorities. 

*  In  a  personal  damage  case  against  a  railroad,  a  member  of  this  con- 
ference, as  counsel,  expressed  his  opinion  of  bias  as  follows:  "it  is  a  general 
rule  that  the  bell  always  rings.     There  is  no  case  on  record  in  which  the 

bell  did  not  ring One  of  the  stock  questions  which  a  railroad 

manager  asks  an  applicant  for  employment  is  'Does  the  bell  ring'?"  Cited 
in  Judicial  Proof,  Wigmore,  p.  394. 


cases  at  all,  but  are  tried  by  judges  and  commissions 
without  a  jury.  In  this  view,  expert  witnesses  may  be 
regarded  as  once  more  in  their  early  position  as  mere 
advisers  of  the  courts  (and  commissions).  Unfortu- 
nately, that  is  not  the  whole  story.  The  grounds  of 
exclusion  for  interest  and  exclusion  of  opinion  both 
bear  on  our  present  question  and  neither  rule,  in  fact, 
rested  entirely  on  the  ground  that  the  jury  was  to  be 
judge  of  the  facts.  The  question  of  bias  and  the  dan- 
ger of  unnecessarily  cumbering  the  record  were  impor- 
tant elements  in  both. 

When  viewed  closely  we  may  find  that  the  reasons 
which  lay  back  of  both  these  rules,  strange  as  it  may 
seem,  at  first  blush,  apply  with  ever  increasing  force  to 
the  expert  testimony,  now  often  the  determining  factor 
in  public  utility  cases.  But  to. see  the  rules  in  their 
true  light  we  must  treat  them  separately. 

VALUATION    EXPERTS    SHOULD    BE    EX- 
CLUDED FOR  BIAS 

Having  already  shown  that  any  attempt  at  valuation 
defeats  genuine  rate  regulation,  I  propose  now  to  show 
that,  if  we  are  to  have  valuation  the  so-called  experts 
offered  by  the  public  utilities  are  incompetent  witnesses. 
In  fact,  they  are  called  experts  only  by  a  false  analogy 
growing  out  of  a  lack  of  scientific  knowledge  on  the  part 
of  the  courts. 

If  we  go  back  to  the  earlier  history  of  expert  wit- 
nesses,^ the  only  persons  permitted  to  give  skilled  or 
expert  testimony  were  scientific  men  called  to  give 
accepted  principles  of  science.  The  only  justification 
was,  that  the  court  might  have  information  on  scientific 
matters — matters  beyond  the  knowledge  and  capacity 
of  the  court  (or  jury).  Then  only  men  versed  in  the 
particular  science  involved  in  the  case  could  be  called. 
Usually  but  a  single  expert  was  heard.  Such  witnesses 
were  called  because  of  their  special  scientific  knowledge 
of  the  question  at  issue.  They  were  supposed  to 
give  a  scientific,  disinterested,  impartial  statement  of 
settled  and  accepted  principles  applicable  to  the  case 
in  hand.  The  courts  always  objected  strenuously  to, 
and  attempted  to  exclude  fancies,  mere  guesses,  and 
theories  not  yet  generally  accepted  by  science.  The 
courts  condemned  diversity  of  expert  opinion  and  spoke 
often  of  principles  universally  accepted  by  science. 
These  were  principles  supposed  to  be  worked  out  in  a 
disinterested  way  by  those  devoting  their  lives  to  that 
particular  science. 

According  to  Webster's  definition  "science"  is  knowl- 
edge duly  arranged  and  referred  to  general  truths  and 
principles  on  which  it  is  founded  and  from  which  it  is 

'  W.  L.  Foster,  11  Harvard  Law  Review,  p.  185,  "He  is  not  a  witness  in 

the  ordinary  sense His  position  and  office  is  that  of  sworn 

interpreter  of  science  to  the  court." 


198 


THE      UTILITIES      MAGAZINE 


derived;  "a  branch  of  learning  considered  as  having  a 
certain  completeness,"  and  "a  systematic  and  orderly 
arrangement  of  knowledge."  Furthermore,  the  same 
definition  states  that  "science  is  always  disinterested" 
and  "is  never  engaged  like  art  in  productive  applica- 
tion." Worcester  also  says:  "and  science  never  is 
engaged,  as  art  is,  in  productive  application." 

Can  the  so-called  utility  experts  qualify  under  any 
part  of  these  definitions?  '  Again,  if  value  is  related 
to  any  science,  it  is  the  science  of  economics,  not  that  of 
engineering  or  accounting,  to  which  the  great  body 
of  company  experts,  so  called,  belong.  If  these  men 
are  pursuing  any  science  and  not  merely  practicing  an 
art,  it  certainly  is  not  the  science  of  value,  nor  any  other 
that  gives  them  a  right  to  speak  scientifically  on  value. 
No  body  of  men  calling  themselves  scientists,  or  gener- 
ally reputed  to  be  scientists,  has  ever,  to  my  knowledge, 
endorsed  or  accepted  as  proved  or  true  the  theories  of 
value  advocated  by  these  witnesses.  In  fact,  no  single 
economist,  so  far  as  I  know,  has  ever  accepted  the  wild 
and  fantastic  theories  of  these  witnesses.  Nor  does 
the  daily  life  and  practice  of  these  high  priced  gentle- 
men concern  itself  with  the  attempt  to  find  a  true  con- 
ception of  value.  Their  lives  are  devoted  rather  to 
profits,  the  art  of  making  money. 

By  no  stretch  of  the  imagination  could  any  one  say 
that,  in  their  ordinary  vocational  life,  they  are  carrying 
on  their  work  with  that  disinterestedness  said  to  be 
required  by  science,  or  that  they  state  on  the  witness 
stand  any  conclusions  of  economic  science — the  only 
science  devoted  to  a  study  of  value.  As  witnesses, 
they  are  trying  to  get  some  unproved  and  unscientific 
theories  accepted  by  the  courts — courts  that  are  not 
economists.  Furthermore,  the  courts  even  are  not  try- 
ing to  find  value  in  a  scientific  sense,  but  in  a  purely 
technical  sense.  Within  the  limits  of  a  hard  and 
inelastic  written  Constitution,  and  the  limitations  of 
the  abstruse  technicalities  of  precedent  law,  they  are 
merely  trying  to  make  decisions  which  will  square  with 
what  they  regard  as  sound  public  policy.  Truly,  these 
witnesses  may  have  put  in  much  time  in  the  attempt  to 
foist  upon  the  courts  certain  theories  financially  advan- 
tageous to  them  and  their  employers,  but  did  any  one 
ever  accuse  these  partisans,  and  advocates,  of  spending 
time  on,  or  off,  the  witness  stand  in  seeking,  in  a  scien- 
tific or  disinterested  way,  to  find  a  scientific  definition 
of  value?  The  total  absence  of  any  reference  to 
economists  or  economic  literature  in  their  testimony  is 
a  sufficient  answer  to  this  inquiry.  Yet  the  science  of 
economics  is  the  only  one  from  which  they  can  draw" 

>  Ibid,  170,  citing  Campbell,  Ld.  C.  J.,  in  Palmer  Murder  Trial,  1856, 
"It  is  in  my  opinion  indispensable  to  the  administration  of  justice  that  a 
witness  should  not  be  turned  into  an  advocate  nor  an  advQcate  into  a 
witness." 


their  principles  on  this  subject,  if  they  have  any  scien- 
tific principles. 

Again,  I  am  reasonably  familiar  with  the  curricula  of 
schools  and  colleges  in  which  these  men  get  their  train- 
ing, and,  I  say,  candidly,  that  with  wholly  unimportant 
exceptions,  these  schools  do  not  teach  or  pretend  to 
teach,  to  any  considerable  extent,  the  sciences  that 
have  to  do  with  wealth  or  the  determining  of  values. 
The  witnesses,  therefore,  have  never  studied  the  matter 
scientifically.  They  are  incompetent  as  expert  wit- 
nesses; and,  under  any  sound  and  logical  interpretation 
of  the  theory  on  which  expert  testimony  is  admissible, 
they  must  be  excluded.  They  have  just  about  as  much 
relation  to  the  expounding  of  the  science  of  value  as 
the  hired  mercenary  troops  of  the  Middle  Ages  had 
to  the  righteousness  of  the  cause  for  which  they 
fought. 

In  short,  the  vast  mass  of  so-called  expert  testimony 
in  utility  rate  cases  has  no  relation  to  any  principles 
accepted  by  the  only  group  of  men  regarded  by  the 
world  as  having  to  do  with  the  scientific  study  or  form- 
ulation of  theories  of  value.  On  the  contrary,  this 
testimony  is  universally  regarded  as  unscientific  by 
economists.  The  witnesses,  therefore,  are  in  no  true 
sense  experts  on  value. 

ALSO  EXCLUDED  FOR  INTEREST 

But  this  matter  has  also  direct  and  important  rela- 
tion to  the  psychological  basis  of  the  rule  of  exclusion 
for  interest.  As  already  indicated  parties  having  an 
interest  in  the  case  were  not  admitted  as  witnesses  in 
either  America  or  England,  until  about  the  middle  of 
the  nineteenth  century.  The  reason  was  simply  that 
their  interest  in  the  issue  was  supposed  to  be  such  as 
to  bias  them  to  such  a  degree  as  to  make  their  testi- 
mony misleading  if  not  vicious.  If  this  was  true  of 
fact,  or  lay,  witnesses  may  it  not  turn  out  to  be  doubly 
true  in  the  case  of  opinion,  or  expert,  testimony? 

Let  us  recur  again  to  Bentham's  famous  argument  in 
favor  of  the  abolition  of  the  opinion  rule.  In  insisting 
that  men  are  not  moved  entirely  by  pecuniary  interest 
he  asks,  "is  there  no  such  thing  as  ambition";  "no 
such  thing  as  love  of  power";  "no  such  thing  as  party 
attachment";  "no  such  thing  as  gratitude,"  and  implies 
that  men  would  not  be  moved  by  ^ch  motives  to  give 
biased  or  false  witness.  In  a  highly  commercialized 
age  and  where  men  are  allied  in  interest  with  certain 
powerful  groups,  where  they  are  giving  opinion  testi- 
mony only,  may  not  these  very  motives  be  the  ones 
that  tempt  men  most  to  testify  against  the  public 
interests?  Further,  do  not  such  motives  exercise  a 
much  more  powerful  influence  on  minds,  action  and 
testimony  of  men  than  they  did  when  Bentham  wrote 
nearly  a  century  ago? 


OPINION      TESTIMONY 


199 


Dean  John  H.  Wigmore,  probably  the  greatest 
authority  on  evidence,  goes  into  a  somewhat  remote 
and  ingenious  explanation  of  why  the  exclusion  rule 
lasted  so  long,  and  ascribes  it,  in  brief,  to  the  fact  that  up 
to  about  1800  men  were  controlled  so  much  more  by 
their  emotions  and  passions  and  their  partisanship 
than  they  are  in  these  latter  days.  "Today,"  he  says, 
"they  are  ruled  in  their  conduct  of  life  by  cool  reason." 
That  one  is  often  surprised  at  the  risk  one  would  run  for 
pure  partisanship,  tradition,  and  sentiment,  a  century 
ago  is  very  true.  But  may  it  not  be,  also,  true  that 
since  the  industrial  revolution,  with  the  breaking  down 
of  personal  relations  and  domestic  ties,  and  the  conse- 
quent changes  in  political  life,  the  public  interest  may 
be  in  quite  as  much  danger  from  the  cool,  devilish, 
logical,  cunning  and  planning  of  cool  reason,  as  from 
any  wild  outbreaks  of  passion  or  partisanship  in  pre- 
vious centuries.  We  must  bear  constantly  in  mind  the 
increasing  inequality  of  wealth  and  remember  how 
much  greater  the  financial  prizes  are  today,  and  how 
much  easier  it  is  for  all  vested  interests  to  combine 
together  than  it  was  in  the  simpler  days.  In  a  com- 
mercialized age,  may  not  the  cooler  and  the  more 
rational  motives  to  which  Dean  Wigmore  refers  be  the 
means  of  accomplishing  the  very  thing  we  are  trying 
to  prevent.'* 

GREED  OR  MERE  EMOTION? 

It  is  true  that  the  change  from  mere  emotional  to 
rational  action  is  probably  one  of  the  greatest  that  has 
come  over  the  world  in  the  intervening  century,  but 
does  it  follow,  as  he  seems  to  think,  that  the  results  so 
far  as  the  matter  we  are  now  discussing  are  concerned, 
are  wholly  favorable  to  the  public  interest  or  conducive 
to  human  justice?  The  great  fortunes  made  possible  in 
an  age  of  machinery,  and  the  concentration  of  industry, 
have  appealed  in  a  powerful  manner  to  the  cool  calcula- 
tion looking  toward  individual  fortune.  May  not  such 
cool  reason  be  quite  as  controlling  of  the  individual's 
conduct,  and  infinitely  more  dangerous  to  the  public 
welfare  as  the  emotional  partisan  struggle  between 
equals,  or  near  equals,  in  the  days  of  Burke,  Byron,  and 
Shelley?  It  is  rather  unfortunate  for  Dean  Wigmore's 
argument  that  this  attack  of  Bentham's  came  at  a  time 
when  the  forces  that  were  making  for  inequality  of  for- 
tune and  acceleration  of  motion  were  on  the  eve  of 
becoming  infinitely  more  dangerous  because  of  the 
increased  inequality  of  wealth  flowing  from  the  new 
machinery.  If  the  more  rational  life  lauded  by  Dean 
Wigmore  spends  itself  exclusively  or  largely  in  acquiring 
individual  fortunes,  may  not  this  rational  life,  in  fact, 
be  quite  as  partisan  and  as  far  removed  from  an  appre- 
ciation of  the  public  welfare  as  the  emotional  partisan- 
ship of  the  eighteenth  century?    He  seems  to  have  an 


inkling  of  this  fact  when  he  says,  "that  influence  no 
doubt  has  in  part  had  its  degrading  effect  in  strengthen- 
ing the  calculative,  sordid,  and  commercial,  standards 
of  action,  but  it  has  also  had  the  effect  of  establishing, 
in  general,  cool  reason  as  the  orthodox  test  of  conduct." 
In  fact,  it  is  from  the  perversion  of  this  very  cool,  cal- 
culating reason  that  we  are  now  suffering.  Until  we 
have  defined  cool  reason,  and  analyzed  some  of  its 
results  more  closely  in  this  connection,  we  must  assume 
that  cool  and  disinterested  reason,  where  one  is  giving 
his  testimony  for  profit  only,  at  so  much  a  day,  may 
lead  to  highly  undesirable  results.  Furthermore,  where 
one's  whole  professional  life  may  be  determined  by  the 
character  of  his  testimony  one  is  quite  as  likely  to  be 
swerved  from  the  line  of  public  duty  by  cool  reason  as 
were  our  ancestors  by  mere  partisanship  and  unreason- 
ing passion.  In  other  words,  is  not  a  cool,  calculating, 
cunning,  nature  quite  as  likely  to  lead  one  into  bias  if 
the  temptation  be  great,  as  was  the  emotional  element 
or  partisanship  of  bygone  ages? 

In  the  sixteenth  and  seventeenth  centuries,  war  was 
carried  on  for  religious  reasons.  Today,  the  nations  of 
the  world  are  grappling  in  a  death  struggle  for  com- 
mercial and  economic  advantage.  The  early  wars  may 
be  said  to  be  due  to  sentimental,  abstract  and  emotional 
causes.  The  present  one  is  a  matter  of  pure  business 
calculation  and  cool  reason.  Is  it  less  injurious,  less 
bloody,  or  more  desirable,  or  commendable,  for  that 
reason? 

Dean  Wigmore  insists  that  the  exclusion  rule  was 
natural  enough  while  the  emotions  dominated,  but  has' 
no  place  in  our  day.  He  then  pays  his  respects  to 
the  presence  of  dominant  passion  today  in  our  South. 
It  may  well  be  questioned,  gentlemen,  whether  the 
emotions  and  passions  which  lead  to  lynchings  and 
general  shootings  in  the  South  are  more  controlling 
of  the  life  of  the  individual  than  the  mercenary  cal- 
culation of  our  Northern  life.  Nor  is  the  second  line 
of  attack  by  Dean  Wigmore  on  the  exclusion  rule,  so  far 
as  it  relates  to  expert  testimony  in  rate  cases,  more 
convincing. 

OVERWHELMING  JUDGE,  JURY,  AND 
COMMISSION 

He  argues  that  the  exclusion  rule  remained  so  late 
because  of  what  he  calls  the  dead  weight  of  an  oath. 
Namely,  the  inclination  to  count  witnesses  rather  than 
weigh  testimony,  and  to  give  the  verdict  to  him  who  had 
the  largest  number  of  witnesses,  irrespective  of  their 
character,  and  that  this  has  disappeared  under  the 
extended  right  of  cross-examination.  This  point  is 
highly  important  and  worthy  of  further  consideration. 

Let  us  look  at  the  conditions  to  which  we  have  come 
and  the  relation  of  these  conditions  to  the  public  utility 


200 


THE      UTILITIES      MAGAZINE 


question.     We  have,  in  this  country,  opened  the  gate 
to  the  most  uninterrupted  pursuit  of  private  gain  that 
the  world  has  ever  seen.     We  have  developed  the  public 
utilities  in  private  ownership  to  a  greater  extent  than 
elsewhere.     This  means  that  it  is  the  field  of  private, 
not  public,  employment  that  offers  a  professional  career 
for  those  who  have  come  to  act  as  expert  witnesses  in 
valuation  cases.     The  difference  between  remuneration 
in   public   employment   in   this   field   and   in   private 
employment  is  so  great  as  to  tempt  every  man  who 
wishes  to  make  a  career  in  this  field  to  refuse  public 
employment,  provided  he  has  reason  to  believe  that  his 
testimony  on  behalf  of  the  public  would  in  anywise  be 
displeasing  to  the  public  utilities  of  the  country.     We 
must  remember  also  that  the  public  utilities  are  allied 
financially  and  by  sympathy,  if  not  otherwise,  with  all 
other  vested  interests.    This  makes  possible  a  boycott 
against  any  members  of  the  profession  giving  expert 
testimony,  by  the  combined  vested  interests  of  the 
country — controlling  the  gateway  to  professional  em- 
ployment and  advancement.     It  is,  perhaps,  needless 
to  remark  that  here  we  have  the  greatest  single  argu- 
ment known  to  the  writer  in  favor  of  public  ownership : 
namely,  in  order  that  we  may  establish  the  eternal  bal- 
ance of  things,  and  thus  create  a  class  of  professional 
men  of  standing  and  real  ability  who  are  willing  to  take 
professional  engagements  from  public  authorities.     Nor 
is  this  the  end  of  the  practical  difiSculty.     What  a  pity 
that  such  men  as  ex-Commissioner  Stevens  could  not 
find  suitable  employment  of  a  scientific  and  disinter- 
ested sort  instead  of  becoming  an  advocate  for  the  cor- 
porations.    When  we  come  to  expert  testimony   we 
find,  first  an  unwiUingness  on  the  part  of  the  great 
majority  of  men  of  ability  to  take  employment  on  any 
terms  on  behalf  of  the  public.     There  is  great  danger 
that  to  do  so  will  destroy  his  professional  career.     He 
becomes,  in  the  language  of  the  day  and  in  the  opinions 
of  the  vested  interests,  unsafe.     This  must  always  be 
borne  in  mind  when  we  come  to  deal  with  the  right  of 
cross-examination.    But  this  is  only  the  beginning  of 
the  diflficulty.     May  not  a  rising  young  engineer  or 
accountant  be  moved  quite  as  powerfully  by  interest 
against  testifying  on  behalf  of  the  public  in  one  of  these 
cases  as  an  eighteenth  century  partisan  was  moved  by 
pure  sentiment  or  emotion.     May  not  the  cool,  rational 
action  and  calculation  of  how  he  is  to  get  on  profession- 
ally count  quite  as  adversely  in  regard  to  bringing  out 
the  truth  as  the  mob  passions  of  our  South? 

HOW  THE  EXPERT  MARKET  IS  CORNERED 

Having  virtually  cornered  the  market  for  talent  the 
utilities  have  at  the  start  a  great  advantage.  In  the 
next  place,  being,  for  essential  purposes,  all  combined, 
they  are  willing  to  pay,  and  do  pay,  much  larger  retain- 


ers, or  fees,  than  are  paid  on  behalf  of  the  pubhc.  This 
tends  to  put  in  their  employment,  in  any  particular 
valuation  case,  all  of  the  men  bearing  well  known  names 
and  making  large  incomes  from  their  professions.  So 
if  we  accept  what  Dean  Wigmore  says  of  the  danger 
from  the  dead  weight  of  an  oath,  we  find  the  utilities 
can,  and  do,  employ  more  witnesses;  we  find  that  they 
pay  each  of  them  better  and  get  men  of  higher  pro- 
fessional reputation.  They  win  out  on  the  basis  of  the 
mere  dead  weight  of  an  oath,  if  you  weigh  testimony 
instead  of  count  witnesses.  They  have  not  only  a 
larger  number  but  the  better  known  names  and  this 
gives  them  a  great  advantage.  Being  expert,  or 
opinion  testimony,  there  is  no  danger  of  conviction  for 
perjury  and  the  judgment  of  the  witnesses  is  inevitably 
swayed  and  virtually  controlled  by  the  payment  of 
large  fees  in  the  past,  and  the  hope  of  professional 
preferment  and  remuneration  in  the  future.  Further- 
more, the  whole  system  tends  to  create  sentiment 
adverse  to  the  public  and  above  all  to  develop  men  who 
worship  large  fortunes,  believe  in  large  industries  and 
despise  smaller  men  and  smaller  units  of  industry. 

Thus,  we  come  to  have  a  philosophy,  not  only  of  life, 
but  of  values,  advantageous  to  the  utilities  rather  than 
to  the  public.  But  what  check  does  the  right  of  cross- 
examination  put  on  this  sort  of  thing?  If  it  is  a  jury 
case,  the  jury  under  our  customs  is  likely  to  consist  of 
men  of  an  altogether  lower  scientific  and  social  rank 
and  status  than  the  expert  witnesses  and  the  clients  of 
the  witnesses.  They  are  likely,  then,  to  be  unduly 
impressed  by  the  importance  and  bearing,  to  say 
nothing  of  the  numbers,  of  men  who  can  command  for 
their  testimony  two  or  three  hundred  times  as  large  a 
remuneration  as  some  of  the  members  of  the  jury  have. 
This  same  argument  applies  in  a  lesser  degree  to  the 
judges  themselves.  It  applies  also  to  a  significant 
extent  to  the  case  of  commissioners  where  we  are  deal- 
ing with  commission  rule  rather  than  with  courts  and 
juries,  so  that  it  is  not  too  much  to  say  that  this  system 
of  allowing  combined  wealth  to  buy  or  engage  all  of 
the  available  talent  at  figures  far  exceeding  the  pay  of 
judge  or  jury,  already  prejudices  the  case  in  favor  of  the 
utilities.  Nor  should  it  be  forgotten,  in  this  connection, 
that,  with  all  of  our  attempts  to  break  away  from  the 
technical  judicial  trial  and  turn  the  regulation  of  utili- 
ties over  to  administrative  officers,  our  progress  in  this 
direction  has  been  small.'  I  question  if  the  weight  of  an 
oath  centuries  ago  had  more  influence  on  verdicts  than 
the  undue  influence  exercised  by  the  utilities  today, 
in  cases  where  the  utilities  virtually  hire  all  the  experts 
of  wide  general  repute  and  so  encumber  the  record  that 
it  is  virtually  impossible  for  judge,  jury,  or  commission, 
to  so  unravel  it  and  to  separate  fiction  from  truth  as  to 

*  Supra,  note  1,  p.  317. 


OPINION      TESTIMONY 


201 


bring  before  the  mind  of  the  tribunal  clearly  the  fact 
that  there  is  any  significant  testimony  whatever  on 
behalf  of  the  public. 

Talk  about  passion;  and  take  Dean  Wigmore's  con- 
fession that  the  tribunal  trying  the  Dreyfus  case  was 
virtually  overwhelmed  by  the  number  and  rank  of  the 
witnesses  for  the  prosecution.  Were  he  writing  today, 
he  probably  would  cite  also  the  disgraceful  case  of  Leo 
Frank.  It  may  be  that  the  Dreyfus  and  Frank  cases 
are  survivals  of  the  eighteenth  centuries — mere  emo- 
tional partisanship  and  prejudice.  They  at  least  show 
the  difficulty,  under  certain  circumstances,  of  opening 
the  gates  wide  to  a  multitude  of  well  known  witnesses 
all  of  which,  under  popular  excitement,  are  on  one  side 
and  have  one  reason  or  another  for  acquiring  that  bias 
which  not  only  makes  them  incapable  of  stating  the 
truth,  but  equally  incapable  of  seeing  it.  Certain 
political,  or  social,  or  economic  views  have  become  so 
crystallized  in  their  minds  as  to  prevent  these  witnesses 
from  seeing  anything  that  does  not  in  their  opinion 
help  toward  a  decision  in  their  favor. 

The  English  judges,  being  much  more  independent 
than  the  American,  avoid  experts  much  more  than  the 
American.  If  they  hear  experts,  they  keep  the  number 
down  to  a  minimum  in  ordinary  cases;  and,  what  is  of 
much  more  importance,  they  insist  that  the  experts 
have  a  thorough  knowledge  not  so  much  of  theories  as 
of  the  particular  facts — unquestioned  facts  of  the  case 
in  hand.  That  is,  they  take  their  opinions  on  facts 
furnished  by  others.  They  thus  try  the  case  on  the 
basis  of  the  facts  of  that  case  and  not  on  that  of  pre- 
conceived and  unproved  theories  framed  from  entirely 
diflFerent  facts  by  witnesses — facts,  too,  that  are  never 
brought  before  the  tribunal  in  the  particular  case  at 
issue. 

This  brings  us  to  another  consideration  bearing  on  the 
same  phase  of  the  problem.  Under  our  worship  of 
private,  as  distinct  from  public,  rights  and  our  emphasis 
of  private  rights  rather  than  pubUc  duties,  and  under 
an  inelastic  written  Constitution,  the  courts  favor  the 
well-to-do  classes  and  property  as  embodied  in  public 
utilities. 

CHANGING    OPINION    AND    PREJUDICE    OF 
TRIBUNE 

As  the  commissioners  on  procedure  said  in  regard  to 
the  public  attitude,  within  a  decade  or  two  before  the 
opinion  rule  was  abolished,  one  who  would  have  pro- 
posed it  twenty-five  years  before  would  have  been 
accounted  a  fanatic.  So  a  short  time  ago  one  who 
raised  the  question  in  this  country  of  the  bias  of  the 
judges  resulting  from  the  unequal  distribution  of 
wealth  and  the  division  into  social  classes  resting  on 
the  inequality,  was  looked  upon  as  guilty  of  treason 


and  as  a  fanatic.  But  within  the  last  decade  there  has 
been  a  widespread  awakening,  not  only  in  the  classes  of 
the  community  having  the  least  wealth,  but  in  the 
higher  financial  and  social  strata  also,  to  the  dangers 
of  this  inequality  and  the  bias  connected  with  it.  For 
instance,  President  Frank  J.  Goodnow,  whom  nobody 
would  regard  as  a  radical,  says'  that  "the  members  of 
the  United  States  Supreme  Court  are  often  taken  from 
the  bench,"  that,  "the  judges  of  the  state  courts  are 
almost  always  chosen  from  the  bar  and  members  of  the 
bar  usually  represent  private  rather  than  public  inter- 
ests." He  says  further,^  "the  Supreme  Court  of  the 
United  States  has  on  the  whole  been  more  liberal  in 
this  attitude  toward  measures  of  regulation  or  positive 
interposition  by  the  states  which  have  deemed  it 
requisite  to  remedy  the  evil  attendant  upon  modem 
industrial  development  as  it  is  seen  in  the  United 
States."  His  conclusion  on  the  bias  '  of  the  courts  is 
"But  there  is  reason  to  believe  that  as  yet  the  courts 
of  this  country  generally,  including  the  supreme  court 
itself,  have  not  been  sufficiently  convinced  of  the  chang- 
ing character  of  political,  social  and  economic  condi- 
tions and  of  the  necessity  of  the  corresponding  flexi- 
bility in  our  law."  "For  the  federal  courts  may,  and 
often  do,  ultimately  determine  for  good  or  for  evil  the 
extent  of  power  which  we  as  an  organized  political 
community  may  exercise  either  in  our  central  or  our 
local  organizations."  * 

Even  so  conservative  a  writer  as  Professor  Taussig 
holds  like  views  in  regard  to  the  bias  and  the  inaccu- 
racies of  testimony  of  experts  in  valuation  cases.* 

It  is  these  courts  that  are  forcing  upon  us  the  doc- 
trine of  fair  value  and  accepting  the'^f ancies  and  hypoth- 
eses of  interested,  incompetent,  expert  witnesses  in 
regard  to  the  proper  methods  of  determining  rates. 

With  the  courts  as  the  final  arbiter  and  really  in  con- 
trol of  the  commissions,  with  the  market  for  talent 
cornered  by  the  public  utilities,  and  with  the  depend- 
ence of  the  expert  witnesses  on  the  favor  of  the  com- 
panies for  future  employment  and  profits,  and  with 
the  overwhelming  numbers  of  experts  now  often  em- 
ployed, the  courts,  juries,  and  commissions,  are  likely, 
under  these  circumstances,  after  having  received  this 
testimony,  to  reject  all  of  the  teachings  of  modern 
science  and  give  the  decision  to  the  dead  weight  of  an 
oath.  In  other  words,  these  tribunals  are  very  much 
in  the  circumstances  of  the  tribunals  that  tried  Drey- 

'  Social  Reform  and  the  Constitution,  p.  331. 

» IMd.,  p.  329. 

» Ibid.,  p.  342. 

*  Social  Reform  and  the  Constitution.     Goodnow.  p.  342. 

'  Cf.  Principles  of  Economics  II,  p.  415.  "  .  .  .  .  The  time  has 
come  for  safeguarding  the  pubh'c  rights  by  making  it  clear  just  what  is  the 
actual  investment  (not  value,  G.)  in  the  monopolies  of  the  present  and 
future." 


202 


THE      UTILITIES      MAGAZINE 


fus  in  France  and  Frank  in  Georgia.  In  short,  they 
are  bowled  over  by  this  imposing  army  of  hired  re- 
tainers. This  reduces  the  whole  subject  of  valuations 
virtually  to  a  farce.  Truly  we  stand  in  the  face  of  the 
danger  so  emphasized  by  President  Taft;  namely,  the 
danger  of  increasing  the  popular  disrespect  for  the 
courts  and  of  developing  in  the  popular  mind  the  feeling 
that  courts,  and  the  law  itself,  are  not  to  be  trusted. 
When  this  point  is  reached,  as  it  has  been  reached  in 
certain  branches  of  the  law  in  some  localities,  as  for 
instance  in  Texas  in  cases  for  personal  damages  alleged 
to  have  been  caused  by  public  utilities,  and  in  various 
instances  in  our  history  where  vigilant  committees  have 
acted.  When  this  point  is  reached,  juries  no  longer 
make  pretense  of  regarding  the  law  or  the  evidence,  but 
decide  wholly  on  their  prejudices.  In  such  cases  the 
law  has  broken  down,  mob  violence  reigns.  It  then 
becomes  as  easy  to  get  a  judgment  for  personal  dam- 
ages against  a  corporation  for  an  unjust  claim  as  for  a 
just  one,  provided  only  that  the  case  in  any  way  be  got 
to  the  jury.  We  seem  to  be  coming  to  this  condition 
of  affairs  in  public  utility  valuations  under  our  present 
false  theory  of  value  and  method  of  using  expert  wit- 
nesses, as  the  main  source  of  evidence. 

CROSS-EXAMININATION    AND    JUDICIAL 
DISCRECTION  INSUFFICIENT 

If  the  foregoing  analysis  has  any  relation  to  the  real 
facts  of  the  case,  it  follows  that  Dean  Wigmore's  plea 
that  we  leave  the  door  wide  open  for  the  admission  of 
testimony  and  trust  to  exposing  error  through  cross- 
examination,  and  the  judgment  of  the  jury  (or  com- 
mission) in  weighing  evidence,  fails. 

Nor  is  the  lawyers'  plea  sound  (voiced  frequently  by 
Dean  Wigmore)  that  the  judge,  having  the  r'ght  to 
limit  the  number  of  experts,  will  safeguard  the  public 
interests  at  this  point  if  only  he  be  allowed  to  retain 
suflficient  discretion.  A  judiciary  that  has  allowed  us 
to  reach  our  present  condition  on  valuation  has  already 
proved  itself  incapable  of  dealing  satisfactorily  with 
this  particular  problem. 

It  is  a  well  known  fact  that  whatever  legal  discretion 
the  courts  and  their  direct  agents,  the  masters  and  com- 
missioners may  have,  they  in  practice  have  lost  the 
power  to  exercise  a  controlling  influence  at  this  point. 
They  merely  act  as  arbitrators  between  the  conflicting 
attorneys  (aided  by  the  experts)  to  make  them  obey  the 
rules  and  allow  them  to  prolong  the  contest  as  long  as 
they  wish.  The  Missouri  Public  Utility  Commission  is 
now  attempting  to  limit  expert  testimony,  while  the 
ex-chairman  of  the  California  Commission  informs  me 
that  he  actually  put  a  limitation  on  this  evil  in  certain 
cases.     It  remains  to  be  seen  whether  these  feeble 


efforts  can  succeed  in  changing  so  ingrained  a  practice 
by  mere  rulings  without  outside  aid. 

But  some  will  say  we  sought  light  on  valuations  that 
we  must  make  under  the  law,  and  you  have  given  us 
nothing  but  theories — theories  that  do  not  help  us  to  do 
what  the  law  commands.     I  would  have  you  take  the 
longer  view,  and  look  towards,  and  work  for,  a  reform 
that  will  be  of  ultimate  beneflt  to  our  civilization.     The 
fact  is,  that  valuation  has  logically  nothing  to  do  with 
rate  regulation.     Although  the  law  in  this  field  leaves 
much  to  desire,  and  is  sufficiently  vague  and  indefinite, 
if  we  take  what  the  United  States  Supreme  Court  has 
actually  decided  on  valuation  and  not  what  it  has  said 
in  its  many  conflicting  and  often  directly  contradictory 
dicta,  valuation  under  existing  laws  has  much  less  to 
do  with  rate  regulation  than  is  generally  supposed. 
Nor  ought  we  to  hesitate  or  be  discouraged  because 
existing  laws  or  even  constitutions,  at  present,  stand  in 
the  way  of  desired  social  changes.     For  when  necessary 
and  desirable  objects  cannot  be  accomplished  under 
existing  laws  and  constitutions,  the  part  of  wisdom,  and 
our  first  duty,  is  to  amend  those  laws  and  constitutions. 
Nor  .would  I  have  it  inferred  from  what  I  have  said 
about   the   exclusion   of   opinion   testimony   and   the 
exclusion  for  interest  that  I  would  have  those  rules 
restored  as  they  existed  till  about  the  middle  of  the 
nineteenth    century.     Such    is    not    my    position.     I 
would  rather  emphasize  the  fact  that  these  rules,  how- 
ever unjust  and  imperfect,  rested  on  an  important 
psychological  basis  and  were  aimed  at  great  and  appall- 
ing evils  and   that  their  abolition  opened   the  gate 
through  our  recent  phenomenal  extension  of  so-called 
expert   testimony   in   rate   cases   to   an   unparalleled 
development  of  the  very  evils  these  old   rules   were 
meant  to  prevent.     Whatever  may  have  been  the  harsh- 
ness and  injustice  wrought  by  these  rules  they  pre- 
vented at  least  the  enormous  evils  from  which  we  are 
now  suffering  in  regard  to  expert  testimony.     My  plea 
simply  is  that  in  getting  rid  of  the  old  evils  we  ought 
not  longer  to  tolerate  or  look  with  indifference  on  such 
evils  as  the  abolition  of  these  rules  permitted  if  it  did 
not  actually  cause. 

Those  who  have  studied  the  United  States  Supreme 
Court  decisions  in  this  field,  with  the  most  care  and  in 
a  disinterested  w(ay,  are  greatly  impressed  with  the  fact 
that  this  court  has  wisely  refrained  from  laying  down 
any  rules  for  arriving  at  the  fair  value  and  have  thus 
left  the  way  open  for  deciding  future  cases  in  the  light 
of  real  needs  and  with  justice  to  all  parties.  They 
further  feel  that  the  actual  decisions,  not  the  mere 
dicta  in  the  cases,  by  this  court  have,  on  the  whole,  been 
eminently  just,  reasonable,  and  fair.  I  freely  admit 
this.    But  we  must  not  jump  at  the  conclusion  that 


OPINION      TESTIMONY 


203 


because  of  this  fact  we  need  have  no  concern  for  future 
justice  in  this  field. 

EXPENSE    PROHIBITIVE,   RECORD   UNMAN- 
AGEABLE 

If  we  bear  in  mind  what  I  have  said  about  the  abuses 
of  expert  testimony,  the  cumbering  and  lengthening  of 
records,  the  protracting  of  trials,  and  the  expense,  we 
can  readily  see  that,  speaking  practically  not  tech- 
nically, justice  is  actually  denied  in  the  vast  majority  of 
cases  before  the  cases  come  to  final  adjudication  by  the 
Supreme  Court  of  the  United  States.  Truly  in  this 
field,  if  ever,  justice  delayed  is  justice  denied. 

It  is  said  that  in  the  Spring  Valley  Water  case  the 
company  introduced  eleven  expert  witnesses.  In  the 
Des  Moines  case  the  company  imported  sixteen  wit- 
nesses from  the  East  and  compelled  the  taking  of  tes- 
timony for  twelve  months.  Of  these  witnesses,  the 
trial  court  said  the  lowest  priced  had  $100  a  day  and 
expenses,  while  one  of  these  witnesses  stated  under 
oath,  in  another  case,  that  his  regular  price  was  $500 
a  day  and  expenses.  I  have  it  from  the  best  of  private 
authority  that  the  company  in  this  case  spent  $150,000 
in  the  trial  court  alone.  It  took  the  city  from  the  time 
the  ordinance  was  passed  December  27,  1910,  to  June 
14,  1914,  to  get  a  favorable  verdict  from  the  Supreme 
Court  of  the  United  States.  What  the  direct  expense 
of  the  litigation  to  the  city  was  it  is  impossible  to  say. 
But  when  such  a  burden  in  time,  money  and  effort,  is 
required  from  a  city  of  about  75,000  population,  think 
of  the  effect  on  this  and  the  hundreds  of  other  smaller 
cities,  in  their  attitude  towards  future  attempts  at 
regulation.  No  wonder  that  Judge  McPherson,  after 
sitting  through  such  a  travesty  of  justice  in  this  par- 
ticular case,  was  moved  to  remark  in  the  decision  that 
such  a  performance  was  to  make  the  winner  of  the  case 
the  real  loser.* 

PRESENT   METHODS   UNIVERSALLY 
EVIDENCED 

Time  fails  me  to  suggest  in  any  detail  such  improve- 
ments as  might  be  made  if  valuations  are  to  go  on.  I 
venture  to  suggest  in  broad  outline  a  few  general  prin- 
ciples. First,  I  admit  that  if  we  are  to  have  valuations, 
expert  testimony  is  necessary;  but  all  parties,  even  the 

'"This  litigation  has  cost  both  the  gas  company  and  city  extravagantly 
large  sums  of  money,  most  of  which  cannot  be  taxed  as  costs,  nor  recovered 
back  by  the  party  successful  in  the  end.  Much  of  this  kind  of  litigation  and 
practically  all  of  the  expense,  would  be  avoided  if  Iowa,  like  so  many  of  the 
others,  including  some  neighboring  states,  had  an  impartial  and  city  non- 
resident Commission,  or  Tribunal  with  power  to  fix  these  rates  at  a  public 
hearing,  all  interested  parties  present,  with  the  Tribunal  soliciting  its  own 
engineers,  auditors  and  accountants.  Too  often  we  have  selfish,  partisan, 
prejudiced,  and  unreliable  experts  engaged  for  weeks  at  a  tune,  at  $100  a 
day,  or  more,  and  expenses  per  day,  exaggerating  their  importance  and 
making  the  successful  party  the  loser."     Des  Moines  Case,  199  Fed.  205. 


lawyers  and  judges,  declare  the  present  system  not  only 
a  failure  but  a  farce.'' 

NECESSARY  REFORMS 

If  experts  are  not,  however,  to  be  entirely  excluded, 
the  following  reforms  are  necessary:  There  must  be 
real  experts  for  the  particular  question  in  hand,  and  not 
merely  self -proclaimed  experts.  They  must  be  less 
partisan  than  at  present,  and  confined  more  to  facts 
produced  by  non-experts.  In  other  words  they  must 
give  their  opinion  primarily  on  the  facts  of  the  case  in 
hand  and  not  cumber  the  record  with  alleged  facts  and 
new  theories  drawn  from  other  facts.  They  must  be 
greatly  limited  in  number,'  appointed  by  the  court,  and 
paid  by  the  public. 

When  these,  or  any  other  reforms,  in  this  matter  are 
proposed,  the  lawyer's  answer,  which  he  considers 
absolutely  conclusive,  is  that  this  is  unconstitutional. 
SuflScient  comment  has  already  been  made  on  this 
point.  His  next  answer  is  that  the  public  would  never 
stand  for  such  expense.     There  is  a  real  difficulty  here, 

'  Wigmore,  Evidence,  §  562.  C.  A.  Endlich,  Amer.  Law  Rev.,  p.  582, 
"an  unmitigated  farce."  Judge  Wm.  Bartlett,  N.  Y.  Amer.  Law  Rev., 
Jan.-Feb.  1900,  p.  4:  "super-partisan."  Amer.  Law  Rev.,  V.  228;  "produc- 
ing the  most  deplorable  confusion  and  conflict":  "hordes  of  experts  levied 
and  enlisted":  "worse  than  useless."  Ix)rd  Campbell,  10  C.  &  F.  154: 
"Hardly  any  weight  is  to  be  given  to  the  evidence  of  what  are  called  scientific 
witnesses.  They  come  with  a  bias  in  their  minds  to  support  the  cause  in 
which  they  are  embarked."  21  Howard  88,  Winans  vs.  A''.  Y.  &  Erie  R.  R.; 
"perplexing  instead  of  elucidating  the  questions  involved  in  the  issue." 

.  .  .  .  opposite  opinions  of  persons  professing  to  be  experts  may 
be  obtained  to  any  amount."  Bouvier,  Law  Diet.,  Rawle's  3d  Ed.;  "is 
in  effect  an  auxiliary  counsel."  Clark  vs.  State,  12  Ohio  489:  "much  assis- 
tance cannot  be  derived  from  metaphysical  speculations"  ....  "a 
farce  to  regard  the  weight  of  evidence  always  on  the  side  which  produced  the 
greatest  numbers."  Grigsby  vs.  Clear  Lake  Water  Co.,  40  Calif.  403:  "advo- 
cates of  the  theory  upon  which  the  party  calling  them  relies";  "Should  not 
be  much  encouraged."  ....  "apt  to  be  prejudiced  in  favor  of  the 
party  by  whom  they  are  engaged."  Judge  E.  Washburn,  Amer.  Law  Rev. 
I,  p.  53:  "starts  with  a  theory";  "the  wish  often  literally  becomes  parent  to 
the  thought";  "danger  ....  of  getting  theory  instead  of  science, 
and  speculation  instead  of  fact";  "biased  by  prejudice  or  warped  by  inter- 
est"; "have  rashly  dogmatized,"  "in  fraud  of  justice  and  in  contempt  of 
truth";  "a  prize  fighter  in  a  ring."  Albany  Law  Journal,  IX,  122,  "If 
science,  for  a  consideration  can  be  induced  to  prove  anything  .... 
then  science  is  generally  open  to  the  charge  of  banality  and  perjury." 

Grier,  J.,  in  Winans  vs.  R.  Co.,  21  Howard  100:  "Wasting  the  time  and 
wearying  the  patience  of  both  Court  and  Jury  and  perplexing  instead  of 
lucidating  the  questions  involved  in  the  issue. "j  In  testimentary  case, 
Cooley,  J.,  Frazer  vs.  Jennison,  42  Mich.  206:  "There  must  be  some  limit 
to  the  reception  of  expert  evidence"  ....  "an  army  may  be  had  if 
the  court  will  consent  to  their  examination"  ....  "and  if  legal 
controversies  are  to  be  determined  by  the  preponderance  of  voices,  wealth 
in  all  litigation  in  which  expert  evidence  is  important  may  prevail  almost  of 
course."  Cited  by  Wigmore,  §  1908.  "Mere  opinions  on  the  value  of 
property  of  this  kind  based  on  superficial  observations  are  of  little  value." 
Wis.  Sup.  Ct.  Duluth  case  N.  W.  R.  152,  898. 

'  The  Canadian  Statute,  1902,  C.  9,  limits  experts  to  five  on  a  side.  The 
Statute  of  Ontario  allows  but  two  on  a  side.  Judge  Cooley  in  Frazer  vs.Jenni- 
aon  recommends  five  on  a  side  at  most,  stating  that  two  are  usually  suflScient. 
English,  French  and  German  courts  rarely  hear  more  than  two  or  three 
in  all.  The  witnesses  in  France  and  Germany  are  not  witnesses  for  sides 
but  official  witnesses  of  the  court. 


204 


THE      UTILITIES      MAGAZINE 


but  it  is  not  the  one  alleged.  In  the  first  place  one 
chief  object  of  reform  is  to  shorten  the  trial,  abbreviate 
the  record,  and  lessen  the  total  expense.  At  present, 
we  allow  the  utilities  to  lengthen  the  trial,  and  pile  up 
the  expense,  partly  to  confuse  the  issue  and  overwhelm 
the  tribunal  in  the  particular  case,  but,  also,  to  frighten 
off  attempts  at  regulation  by  making  the  public  author- 
ities afraid  of  such  protracted  trials,  if  any  regulation  is 
attempted.  In  fact,  we  are  in  this  matter,  today,  about 
where  we  were  thirty  years  ago,  in  regard  to  personal 
damage  suits  against  railroads.  It  is  a  well  known  fact 
that  many  railroads  fought  suits  where  they  knew  they 
could  not  win, — just  as  bitterly  as  where  they  knew  the 
plaintiff  had  no  chance  to  win — merely  for  the  sake  of 
frightening  off  just  suits  because  of  the  probable  cost 
of  litigation.  At  present,  we  allow  the  utilities  in  valu- 
ation cases  to  go  to  any  expense  themselves  and  to  put 
the  public  to  almost  unlimited  expense,  and  then  to 
collect  all  their  costs  from  the  public  in  the  form  of 
rates  and  charge  it  all  to  operating  expenses.*  We  then 
raise  the  valuations  to  enable  them  to  recoup  their 
costs  while  the  public  has  often  been  forced  to  pay  more 
directly,  in  contesting  the  suits,  than  the  whole  case 
would  have  cost  if  it  had  not  been  needlessly  prolonged. 
This  method  of  valuation,  then,  with  its  accompani- 

•  The  Missouri  Commission  has  recently  refused  to  consider  such  an  ex- 
penditure as  an  operating  charge  in  two  different  cases.  1  Mo.  P.  S.  C. 
5,411.645:  2  Mo.  P.  S.  C.  363. 


ment  of  unlimited  experts  and  false  theories  of  value, 
gives  the  companies  virtually  unlimited  funds  for 
defeating  the  public  rights.  We  may  have  to  apply  to 
such  valuations  the  general  theory  the  law  applies  to 
damages  for  torts;  namely,  refuse  to  take  any  testimony 
in  regard  to,  or  make  any  allowance  for,  merely  theoret- 
ical, uncertain,  or  speculative  elements.^  It  is  the  tak- 
ing of  expert  opinion  on  theories,  not  on  facts,  that  we 
must  guard  against. 

When  the  number  of  experts  is  reasonably  limited 
and  the  trials  properly  shortened,  the  expense  will 
probably  not  be  greater  than  the  present  futile, 
direct  expense  to  the  public  treasury  is.  Certainly  it 
will  be  much  less  than  the  total  burden  today,  when  the 
public  must  repay  the  companies  in  rates  for  all  the 
unnecessary  expenses  incurred  in  defeating  regulation. 

But  with  the  growing  complexity  of  life,  the  expense 
of  regulation  will  always  be  great.  The  Utilities  Bureau 
has  no  more  serious  duty  before  it  than  to  teach  the 
public  that  to  control  vast  aggregations  of  capital,  a 
large,  skilled,  expensive  and  permanent  force  of  real 
experts  is  necessary.     Pigmies  can  never  control  giants. 

'  Nelson,  C.  J.,  in  Lincoln  vs.  R.  Co.,  23  Wendell  434:  "In  the  nature  of 
the  case  no  set  or  series  of  facts  exists  to  which  the  application  of  their  (the 
witnesses)   peculiar  knowledge  would  naturally  lead  with  anything  like 

mathematical   certainty Even   with   the  jury   the   damages 

beyond  the  actual  expenses  out,  can  at  best  rise  but  little  ab<ive  conjecture." 
Does  the  expert  testimony  rise  above  conjecture?  Cited  by  Wigmore, 
Evidence,  §663. 


THE  MEANING  OF  THE  CONSTITUTIONAL  PROTECTION 

IN  VALUATION 

By  Charles  A.  Prouty 

Director  of  Valuation,  Interstate  Commerce  Commission 


THE  term  "valuation"  as  used  in  this  discussion 
refers  to  valuations  made  by  public  authority 
in  pursuance  of  legislative  direction.  It  is  only 
recently  that  such  valuations  have  been  made  to  any 
considerable  extent,  and  so  far  as  I  know  there  is  no 
case  which  directly  decides  the  question  considered. 
An  answer  to  that  question  must  be  sought  by  reference 
to  general  principles.  The  adjudicated  'cases  from 
which  those  principles  flow  are  numerous,  voluminous 
and  not  harmonious.  The  time  does  not  suffice  and 
no  attempt  will  be  made  to  state  or  analyze  the  cases 
themselves;  only  a  statement  of  what  is  understood  to 
be  the  law  will  be  given. 

RATE   MAKING  A  LEGISLATIVE   FUNCTION 

The  first  and  the  most  important  of  these  principles 
is  that  the  function  of  rate  making  is  legislative  * 
"To  prescribe  rates  which  shall  be  charged  in  the  fu- 


ture— that  is  a  legislative  act."  This  language  was 
used  by  the  Supreme  Court  in  a  famous  case  many 
years  ago,  and  while  that  court  had  made  decisions 
before  and  may  have  made  decisions  since  which,  upon 
their  face,  are  not  altogether  consistent  with  this  lan- 
guage, the  statement  itself  has  never  been  modified  and 
is  today  the  law.  The  legislature  may  make  the  rate 
by  direct  enactment,  as  has  frequently  been  done,  or  it 
may  create  a  commission  and  delegate  to  it  the  author- 
ity. Perhaps  I  should  not  use  the  word  "delegate" 
since  in  theory  the  legislature  cannot  entrust  to  another 
its  legislative  powers.  It  has  been  earnestly  objected 
before  the  courts  that  the  rate  making  authority  of 
pubhc  service  commissions  was  unconstitutional  be- 
cause it  involved  a  delegation  of  legislative  authority, 
but  where  the  necessity  exists  even  courts  will  usually 
find  a  way,  and  it  is  elementary  law  today  that  a  com- 


CONSTITUTIONAL    PROTECTION    IN    VALUATION 


205 


mission  may  be  "  invested "  with  what  is  equivalent  for 
all  practical  purposes  to  full  rate  making  powers. 

The  full  significance  of  this  fact,  that  the  authority 
to  make  a  public  utility  rate  for  the  future  is  legislative, 
should  be  appreciated.  Under  the  federal  Constitu- 
tion and  under  most,  if  not  all  of  our  state  constitutions, 
the  powers  of  government  are  divided  between  different 
departments  and  one  department  cannot  exercise  the 
authority  of  another  department.  A  judge,  for  ex- 
ample, cannot  set  aside  an  act  of  the  legislature  simply 
because  he  beUeves  it  to  be  an  unwise  or  pernicious  law; 
he  must  find  that  the  enactment  of  the  statute  is  for 
some  reason  unlawful.  If,  therefore,  the  making  of  a 
rate  is  legislative,  courts  have  no  power  and  cannot  be 
invested  with  the  power  to  re- 
view the  reasonableness  of  that 
rate  as  a  question  of  fact;  that 
is,  the  judge  cannot  modify  or 
alter  the  rate  simply  because  he 
beheves  that  it  is  too  high  or 
too  low  or  otherwise  wTong. 
Before  he  can  interfere  the  un- 
lawfulness of  the  rate  must  in 
some  manner  appear. 


LEGISLATURE  CAN  REG- 
ULATE, NOT  DESTROY 


PART  xn 

CONSTITUTIONAL  PROTECTION 
IN  VALUATION 


THE  MEANING  OF  CONSTITUTIONAL  PRO 
TECTION 


The  language  quoted  in  the 
opening  sentence  was  used  by 
the  Supreme  Court  in  1897,  but 
that  coiu"t  had  years  before  in 
the  Granger  cases  held  that  the 
people  might  regulate  the  rates 
of  transportation  to  be  charged 
by  our  railroads  and  that  this  regulation  might  be  ac- 
complished by  fixing  the  rates  of  transportation.  Public 
feeling  against  railroads  at  that  time  was  extremely 
high  and  it  speedily  became  apparent  that  the  legisla- 
tures would  abuse  the  authority  which  they  had  thus 
acquired.  When  confronted  with  this  possibility  Chief 
Justice  Waite,  who  had  written  the  opinion  holding  that 
the  right  to  regulate  by  legislative  enactment  existed, 
qualified  the  exercise  of  that  right  by  the  well-known 
phrase,  "This  power  to  regulate  is  not  a  power  to  de- 
stroy." While  volumes  have  since  been  written  upon 
this  subject,  and  while  the  Supreme  Court  itself  has 
covered  pages  in  explaining  the  origin  and  defining  the 
limits  of  its  power  in  this  respect,  it  may  be  doubted 
whether  this  simple  statement  can  be  improved  upon. 
The  legislature  may  regulate,  it  may  not  destroy;  and 
when  regulation  goes  to  the  point  of  destruction  the 
courts  will  interfere.  The  legislature  or  its  commission 
may  make  the  rate  and  the  reasonableness  of  that  rate 
cannot  be  inquired  into  by  the  coiu-t,  but  when  the  effect 


WHEN  FAIR  VALUE  AS  FIXED  BY  COMMIS- 
SIONS IS  CONCLUSIVE 

THE  PRACTICAL  SIGNIFICANCE  OF  CONSTI- 
TUTIONAL PROTECTION 

WHAT  IS  THE  "PROPERTY"  OF  A  PUBLIC 
UTILITY 


VALUE  AFFECTED  BY  CONTRACT 

VALUE  AS  INTERPRETATION  OF  CONTRACT 

THE   PROPERTY    THAT   IS   DEDICATED    TO 
PUBLIC  USE 


of  that  rate  is  to  confiscate  the  property  of  the  utility, 
the  bounds  of  just  regulation  are  transcended  and  the 
utility  may  appeal  to  the  courts  for  protection. 

TWILIGHT  ZONE 

Much  earnest  controversy  has  been  waged  over  the 
relative  powers  of  court  and  commission  in  the  making 
of  the  rate.  The  Supreme  Court  of  the  United  States 
has  in  recent  years  announced  several  important  de- 
cisions in  which  the  principles  governing  this  question 
are  laid  down.  Today  this  can,  I  believe,  be  affirmed 
with  certainty:  there  is  a  line  above  which  the  rate  is 
clearly  sufficiently  high  and  as  to  all  territory  beyond 
this  line  the  conclusive  power  of  the  commission  is 

clear.  There  is  another  line  be- 
low which  the  rate  is  clearly 
too  low  and  any  rate  in  that 
territory  would  be  unlawful  and 
would  be  set  aside  by  the  courts. 
Between  these  two  lines  is  an 
area  within  which  the  vision  is 
not  clear.  Within  these  hmits 
honest  men  may  differ.  Now 
whose  judgment  shall  control 
within  this  region  of  uncer- 
tainty; shall  it  be  the  court  or 
the  legislature?  Just  this  was 
the  bone  of  contention  and  the 
courts  themselves  have  finally 
answered  in  favor  of  the  legis- 
lature. When  once  it  is  deter- 
mined that  the  rate  falls  within 
this  region  of  doubt,  the  com- 
mission is  supreme. 
The  limits  of  this  so-called  twilight  zone  will  differ 
with  the  utility  involved,  with  the  conditions  influenc- 
ing the  rate,  with  the  attitude  of  the  public,  and  with 
the  temper  of  the  court,  but  that  this  region  of  doubt 
exists  and  that  its  limits  are  broad  enough  to  most 
profoundly  affect  the  welfare  of  our  public  utilities, 
particularly  our  carriers  by  rail,  the  most  important  of 
all,  cannot  be  questioned. 

The  private  property  which  the  public  utility  uses  in 
the  service  of  the  public  is  entitled  to  a  fair  return  upon 
its  fair  value.  To  deny  this  measure  of  return  is  to 
confiscate  the  property  within  the  meaning  of  the 
courts.  Two  things  must  be  known.  First,  it  must 
h%  determined  what  rate  of  return  shall  be  allowed  upon 
each  dollar  of  investment,  and  second,  it  must  be  known 
how  many  dollars  are  invested;  that  is,  what  is  the 
value  upon  which  a  return  shall  be  allowed.  I  do  not 
mean  that  the  making  of  a  rate  is  a  mathematical 
problem  which  can  be  solved  when  the  rate  of  retiu-n 
and  the  value  of  the  property  are  known,  but  I  do  mean 


206 


THE      UTILITIES      MAGAZINE 


that  the  allowance  of  this  fair  return  should  be  a  fun- 
damental inquiry  in  the  rate  making  and  that  it  is  a 
universal  limitation  upon  the  rate-making  action  of 
the  legislature  or  commission.  It  must  follow  that 
before  the  function  of  rate  making  can  be  intelligently 
discharged,  the  value  of  the  property  to  be  affected 
must  be  known. 

HOW  FAR  VALUATION  OF  COMMISSION 
IS    CONCLUSIVE 

This  fact  has  not  always  been  apparent  in  the  past 
but  it  is  coming  to  be  recognized  more  and  more.  In 
some  way  the  fair  value  of  the  property  of  our  public 
utilities  must  be  determined.  Legislatures  in  recog- 
nition of  this  fact  are  investing  public  commissions  with 
authority  to  make  these  valuations.  Now  when  a  com- 
mission under  legislative  authority  values  the  property 
of  a  public  utility  for  the  purpose  of  using  that  valua- 
tion in  its  rate  making  process,  it  discharges  an  essen- 
tial part  of  the  legislative  duty  which  rests  upon  it. 
If  it  were  to  be  held  that  the  courts  should  fix  this 
value,  the  legislative  department  would  be  largely 
deprived  of  its  legitimate  authority.  It  has  seemed  to 
me,  therefore,  that  it  would  finally  be  held  that  the 
action  of  the  commission  in  fixing  the  value  was  con- 
clusive within  the  same  limits  and  to  the  same  extent 
as  is  its  action  in  the  fixing  of  the  rate.  This  falls 
within  the  principle  of  that  line  of  decisions  which  hold 
that  where  the  determination  of  a  fact  is  essential  to 
the  exercise  of  an  executive  or  administrative  duty,  the 
correctness  of  that  conclusion  cannot  be  questioned  by 
the  courts.  When  the  Secretary  of  War  had  found  that 
the  bridge  across  the  river  at  Pittsburgh  was  an  obstruc- 
tion to  navigation,  it  became  such  obstruction.  When 
the  immigration  authorities  determined  that  the  indi- 
vidual was  a  Chinaman  not  entitled  to  admission  into 
the  United  States,  that  question  of  fact  was  foreclosed. 

The  courts  will,  of  course,  correct  all  legal  errors 
which  may  be  made  in  the  process  of  valuation  but,  if 
the  above  theory  is  correct,  will  not  review  conclusions 
of  fact. 

It  is  not  contended  that  courts  can  be  or  should  be 
divested  of  the  right  to  inquire  into  the  value  of  the 
property  affected.  The  question  of  confiscation  is 
always  open.  In  passing  upon  that  question,  the 
value  of  the  property  is  a  most  important  consideration 
which  must  be  inquired  into  like  any  other  fact.  But 
the  purpose  of  the  whole  legal  proceeding  must  ever  be 
kept  in  mind.  It  is  not  to  determine  whether  the  rate 
fixed  is  a  reasonable  one,  but  rather,  whether  it  so 
far  passes  the  Hmits  of  just  regulation  as  to  destroy  the 
property  of  the  utility.  This  is  the  single  question  and 
in  answering  this  the  rate  and  the  valuation  must  go 
together.     Confiscation  may  be  aflfirmed  either  because 


the  rate  is  too  low  or  the  valuation  too  low,  but  the  same 
rule  should  be  applied  to  one  as  to  the  other. 

WHEN  SHOULD  COURT  PASS  UPON 
VALUATION? 

In  passing  it  may  be  interesting  to  inquire  at  what 
time  the  courts  shall  pass  upon  the  valuation;  shall  it 
be  when  that  valuation  is  completed  or  when  it  is  first 
involved  in  some  judicial  proceeding? 

It  has,  I  believe,  sometimes  been  provided  by  the 
statute  directing  the  valuation  that  the  commission 
upon  the  completion  of  its  work  should  present  the 
result  to  the  court  and  that  the  court  upon  notice  to 
the  utility  affected  and  upon  due  hearing  should  enter  a 
judgment  establishing  the  valuation,  if  found  to  be 
lawful.  A  valuation  thus  established  is  conclusive  upon 
the  parties.  The  Valuation  Act  of  March  1,  1913, 
under  which  the  federal  commission  is  proceeding,  does 
not  provide  for  any  reference  to  the  court  either  pend- 
ing or  at  the  close  of  the  valuation.  A  tentative  result 
must  be  served  upon  the  utilities  affected  and  upon 
certain  representatives  of  the  public,  and  the  commis- 
sion upon  hearing  may  correct  its  tentative  report  and 
establish  a  final  valuation.  If  this  valuation  is  subse- 
quently presented  in  any  legal  proceeding,  it  is  to  be 
prima  facie  evidence  but  may  apparently  be  collater- 
ally attacked. 

The  making  of  the  valuation  is  an  essential  part  of 
the  rate-making  duty  of  the  commission.  The  rate 
itself  cannot  be  properly  established  until  the  correct 
value  is  known.  Both  the  public  and  the  utility  are 
therefore  immediately  interested  in  the  valuation  which 
is  established.  It  has  always  seemed  to  me  that  any 
question  as  to  the  correctness  of  that  valuation  raised 
a  controversy  between  the  utility  upon  the  one  hand 
and  the  public  upon  the  other,  which  might  be  made 
cognizable  by  the  courts.  This  is  not  a  moot  question. 
If  this  be  so  the  legislature  can  undoubtedly  provide 
that  the  utiUty  shall  within  a  certain  time  file  its  ob- 
jection to  the  valuation  in  court  to  be  duly  examined 
and  passed  upon,  or,  faiUng  to  do  so,  shall  stand  fore- 
closed for  the  future.  Speaking  of  the  federal  valua- 
tion, it  has  always  seemed  to  me  that  it  would  be  highly 
desirable  if  in  some  way  reference  might  be  had  to  the 
courts  as  the  work  progresses,  since  otherwise  the  com- 
mission may  proceed  upon  some  misconception  of  law 
which  cannot  be  known  until  it  is  too  late  to  be  cor- 
rected. 

Another  thought  should  perhaps  be  noted.  Up  to 
the  present  time  judicial  decisions  touching  matters  of 
valuation  have  not  usually  been  rendered  in  respect 
of  valuations  made  by  public  authority,  but  rather  upon 
valuations  presented  for  the  first  time  in  some  judicial 
proceeding,  usually  by  the  utility  itself  but  sometimes 


CONSTITUTIONAL  PROTECTION  IN  VALUATION 


207 


by  the  government.  The  legal  presumptions  in  case 
of  such  valuations  may  be  entirely  different  from  what 
they  would  be  if  the  valuation  had  been  made  by  a 
commission  as  part  of  its  appointed  duty  under  the 
direction  of  the  legislature. 

PRACTICAL    SIGNIFICANCE    OF    CONSTITU- 
TIONAL PROTECTION 

Coming  back  now  to  our  subject  and  summing  up 
the  whole  matter;  what  is  the  practical  significance  of 
this  constitutional  protection?  How  far  does  it  con- 
strain the  commission?  How  far  does  it  protect  the 
utility? 

This  will  depend  upon  a  variety  of  conditions  and 
considerations.  It  will  depend  upon  the  character  of 
the  utility.  A  gas  plant  serving  a  single  community, 
with  no  competition,  whose  revenues  can  be  accurately 
gauged  both  upon  the  new  and  the  old  rate,  and  whose 
operating  expenses  are  exactly  known,  presents  a  very 
simple  problem.  There  is  some  doubt  possible  as  to 
the  rate  of  return  which  should  be  allowed.  There  is 
some  question  as  to  the  amount  of  depreciation.  The 
really  doubtful  part  of  the  whole  problem  is  the  valua- 
tion itself.  Now,  it  has  always  been  my  feeling  that, 
with  this  sort  of  a  utility,  the  limits  of  the  twilight  zone 
would  be  extremely  narrow,  and  that,  even  in  the  val- 
uation itself,  the  court  would  not  be  inclined  to  allow 
great  latitude  of  judgment.  The  questions  of  fact 
which  enter  into  that  valuation  are  so  comparatively 
easy  of  determination  that  all  reasonable  men  must  have 
substantially  the  same  opinion. 

Compare  with  this  the  question  presented  in  the 
fixing  of  railroad  rates  of  transportation.  Here  are  all 
kinds  of  competition,  between  carriers,  between  places, 
between  commodities.  The  rate  under  which  one  car- 
rier can  live  will  put  its  competitor  out  of  business. 
There  is  no  immediate  connection  between  the  value 
of  a  particular  property  and  the  rate  to  be  applied  to 
that  property.  The  whole  subject  is  involved  in  doubt 
and  is  peculiarly  a  matter  of  judgment  about  which  the 
opinion  of  the  commissioner  with  years  of  experience, 
who  has  come  to  have  a  sort  of  rate  making  sense,  so 
to  speak,  is  of  value.  In  such  a  case  the  limits  of  this 
zone  of  doubt  must  of  necessity  be  much  wider.  The 
valuation  itself  will  be  scrutinized  much  less  closely. 
While  the  legal  rule  may  be  the  same,  the  application  of 
that  rule  will  be  altogether  different. 

Much  will  depend  upon  the  disposition  manifested  by 
the  commission  itself  in  the  making  of  the  valuation. 
If  it  be  evident  that  that  body  has  acted  with  an  open 
mind,  has  honestly  endeavored  to  do  entire  justice  in 
the  premises,  is  ready  to  correct  error  against  the  utility 
when  its  mistake  appears,  the  court  will  accord  to  its 
work  a  much  different  treatment  than  as  though  the 


contrary  appeared.  This  is  well  illustrated  by  a  recent 
case  in  the  Supreme  Court  of  the  United  States  which 
is  often  referred  to. 

The  Cedar  Rapids  Gas  Company  had  been  required 
by  ordinance  to  charge  a  certain  rate  for  gas  and  had 
applied  to  the  state  court  for  an  injunction  restraining 
the  enforcement  of  this  ordinance.  The  case  finally 
reached  the  Supreme  Court  of  the  state,  which  after  a 
careful  and  elaborate  consideration  of  the  matter  dis- 
missed the  petition,  stating,  however,  that  the  company 
might,  after  an  actual  trial,  again  apply  to  the  court  if 
the  results  of  experience  justified  it.  From  this  de- 
cision of  the  state  court  a  writ  of  error  was  taken  by 
the  company  to  the  Supreme  Court  of  the  United  States. 
That  court  dismissed  the  suit.  The  opinion  has  been 
referred  to  as  deciding  several  things.  To  my  mind  it 
decides  nothing.  The  court  simply  says  that  the  atti- 
tude of  the  state  court  toward  the  plaintiff  in  error  is  a 
perfectly  fair  one  and  that,  this  being  so,  it  will  require 
a  perfectly  clear  case  to  induce  the  Supreme  Court  to 
interfere.  This  is  the  paramount  lesson  of  the  Cedar 
Rapids  case. 

Much  will  depend  upon  the  temper  of  the  court.  In 
the  popular  apprehension  the  judge  simply  declares  the 
law  uninfluenced  by  popular  clamor  or  by  personal  feel- 
ing. And  this  in  the  main  is  correct.  The  judge  will 
apply  a  statute  even  though  he  believes  it  to  be  per- 
nicious. He  will  follow  a  decision  although  to  his  mind 
that  decision  is  utterly  wrong;  but  here  there  is  neither 
statute  to  apply  nor  decision  to  follow.  Every  case 
is  a  law  unto  itself.  Does  this  act  of  the  commission 
transcend  the  bounds  of  just  regulation?  Does  it 
confiscate  the  property  of  the  utility?  This  is  a  ques- 
tion of  opinion,  of  judgment,  of  discretion,  and  the 
answer  will  be  profoundly  affected  by  the  attitude  of 
the  public  and  the  mental  habit  of  the  judge  himself. 
In  the  twenty  years  during  which  I  have  had  to  do 
with  this  general  subject  there  has  been  a  wonderful 
transformation  in  the  disposition  of  the  courts  toward 
this  class  of  cases. 

IMPORTANCE  OF  PUBLIC  SERVICE 
COMMISSION 

The  constitutional  protection  as  applied  to  valua- 
tion means  this:  Errors  of  law  will  be  corrected.  The 
courts  will  restrain  arbitrary  and  unwarranted  action. 
They  will  not  and  can  not  protect  against  errors  of 
judgment.  They  cannot  secure  to  the  utility  reason- 
able rates.  There  are  wide  limits  within  which  the 
legislature  and  legislative  commission  are  supreme. 

If  this  be  true  the  public  service  commissions  of  this 
land  largely  control  the  welfare  of  our  public  utilities. 
This  should  be  clearly  understood.  No  public  oflficial 
today  discharges  a  duty  of  greater  delicacy  than  does 


208 


THE      UTILITIES      MAGAZINE 


the  public  service  commissioner.  Upon  the  one  hand, 
he  is  the  advocate  and  guardian  of  the  public  interest, 
which  usually  has  in  the  questions  coming  before  him 
no  other  supporter,  while  at  the  same  time  he  must 
stand  as  a  judge  between  the  patron  of  the  utility  and 
the  utility  itself.     It  is  of  equal  importance  to  the  util- 


ity and  the  public  that  only  men  of  the  highest  type 
should  be  selected  for  these  positions,  and  that,  when 
once  selected,  they  should  be  assisted  and  supported  in 
the  discharge  of  their  duties.  Upon  the  quality  of  these 
commissioners  the  ultimate  success  of  public  regulation 
depends. 


CONSTITUTIONAL  PROTECTION  IN  VALUATION 


By  Wiluam  D.  Kerr 

Attorney  at  Law,  Chicago,  III. 


THE  mathematical  process  of  multiplication  con- 
sists of  applying  a  multiplier  to  a  multiplicand. 
The  resulting  product  is  affected  equally  by 
the  value  of  each  factor. 

The  legal  process  of  valuing  public  utility  property 
to  determine  whether  a  given  rate  or  service  regulation 
conflicts  with  the  14th  Amendment  is  similar  to  multi- 
plication. A  multiplier,  value,  is  applied  to  a  multi- 
phcand,  property.  The  product  is  the  ultimate  value, 
which,  under  the  rulings  of  the  Supreme  Court,  is  pro- 
tected by  the  Constitution. 

The  science  of  mathematics  has  evolved  a  distinctive 
terminology,  the  use  of  which  is  free  from  confusion  and 
obscurity.  The  science  of  law  has  not  been  so  fortu- 
nate. For  in  the  legal  process,  the  same  term,  "  value," 
is  appUed  alike  to  the  multiplier  and  to  the  product. 
The  factor,  however,  is  none  the  less  distinct  from  the 
product,  which  it  reaches  only  by  combination  with 
property. 

In  multiplication,  if  the  first  factor  be  halved  and 
the  second  doubled,  the  product  remains  the  same. 
In  valuation,  if  elements  of  value  are  deducted  from  one 
factor  and  corresponding  elements  of  property  are 
added  to  the  other,  the  resulting  ultimate  value  will  be 
unchanged.  But  if  in  valuing  a  public  utility  plant  all 
elements,  whether  of  value  or  of  property,  are  weighed 
with  reference  solely  to  the  one  factor  or  the  other 
alone,  some  may  be  excluded  which  belong  in  the 
product  while  others  may  be  included  which  do  not. 

DECIDED  CASES  ARE  PRECEDENTS 

In  valuations,  the  product  has  a  great  and  far- 
reaching  influence.  Ultimate  value  is  a  measure  of 
taxing  power  and  a  limitation  of  vested  property  rights. 
Each  has  great  social  and  economic  consequences.  In 
the  effort  to  reach  a  result  commendable  from  the 
standpoint  of  equity  and  good  conscience,  an  entirely 
proper  addition  or  deduction  may  be  made  in  the 
wrong  factor.  This  would  not  be  a  serious  matter  if 
a  solved  problem  exercised  no  influence  on  succeeding 


problems  presented  for  solution.  Such  is  not  the  case 
in  applying  the  14th  Amendment  to  valuations  for 
rate  making. 

It  is  proposed  in  this  paper  to  examine  the  nature  of 
the  property  which  is  protected  by  the  14th  Amend- 
ment. The  title  of  the  paper  is  Constitutional  Protec- 
tion in  Valuation.  Only  in  a  figurative  sense  is  the 
title  correct,  however.  The  paper  deals  with  the 
measuring  of  property  rights  rather  than  with  the 
manner  or  method  of  valuing  ascertained  property 
rights.  Consider  that  the  problem  of  the  Supreme 
Court  in  these  14th  Amendment  cases  is  represented 
by  the  formula: 

x=p: 

X  will  be  the  fair,  present  value  sought  to  be  deter- 
mined, P  will  be  the  property  of  the  utility  and  the 
exponent,  v,  the  rule  of  value.  I  ask  you  for  the  next 
few  minutes  to  eliminate  from  your  consideration  both 
X  and  V  and  to  concentrate  yoiu*  attention  on  P  alone. 

WHAT  IS  "PROPERTY"  OF  PUBLIC  UTILITY? 

What  is  the  "property"  of  a  "person"  engaged  in  a 
public  calling?  Is  the  quality  of  such  property  affected 
by  the  person  being  a  corporation?  Does  voluntary 
assumption  of  the  obligation  to  serve  the  public  at 
reasonable  rates  limit  in  law  the  rights  of  ownership 
that  may  be  acquired  in  things  both  tangible  and 
intangible?  A  distinction  between  "value  for  rate 
making  purposes"  and  value  for  certain  other  purposes 
is  found  to  exist  in  the  case  of  some  species  of  property. 
Does  this  point  to  the  existence  of  an  element  limiting  or 
qualifying  property  rights  in  things  dedicated  to  public 
use?  Are  the  facts  material  and  relevant  to  the  trial 
of  an  issue  of  "value"  under  the  14th  Amendment,  the 
same  facts  that  would  be  material  and  relevant  to  the 
trial  of  an  issue  of  "property"  under  the  same  provision 
of  the  Constitution? 

These  questions  are  suggested  by  the  scope  and 
tendency  of  the  lay  discussion  of  the  valuation  ques- 
tion, and  by  results  reached  in  cases  decided  by  the 


CONSTITUTIONAL    PROTECTION    IN    VALUATION 


209 


Supreme  Court.  The  nature  and  ramifications  of  the 
lay  discussions  are  illustrated  by  the  proceedings  of  this 
Valuation  Conference.  Here  are  found  "reproduction 
value"  contrasted  with  "fair  value";  "actual  cost"  on 
the  one  hand  and  "original  cost"  on  the  other,  con- 
sidered as  a  basis  for  "fair  value";  "depreciation" 
treated  as  a  factor  in  "fair  value";  and  "going  value" 
dealt  with  as  an  element  of  "fair  value."  In  general, 
there  is  a  distinct  line  of  cleavage  between  the  propo- 
nents of  a  "reproduction  value"  theory  and  of  a 
"historical"  theory  of  value,  the  former  of  which  seems 
based  on  a  conception  of  absolute  value  applied  to 
exclusive  property  rights  and  the  latter,  on  relative 
or  qualified  values.  "Value"  is  said  by  some  to  be 
determined  by  the  status  of  the  corporation,  which  is 
regarded  on  the  one  hand  as  an  independent,  self- 
possessed  individual,  and  on  the  other  hand,  literally 
as  the  agent  of  the  state. 

INCONSISTENCIES  IN  COURT  DECISIONS 

The  results  reached  by  the  Supreme  Court  present 
seeming  inconsistencies.  Apparently  in  a  search  for 
value,  the  court,  in  Omaha  vs.  Omaha  Water  Co.,  218 
U.  S.  180,  approved  a  separate  allowance  and  appraisal 
of  going  value.  This  was  a  purchase  case.  The  city 
of  Omaha  was  required  to  complete  the  purchase  of 
the  company's  plant  at  a  price  that  included  this  allow- 
ance. In  Des  Moines  Gas  Co.  vs.  Des  Moines,  238  U.  S. 
153,  the  court  approved  a  valuation  in  which  the 
appraiser  "considered"  going  value  only  to  the  extent 
of  valuing  the  physical  properties  at  their  full  repro- 
duction cost,  less  depreciation.  The  appraiser  found 
specifically,  however,  that  a  seller  would  require,  and  a 
buyer  would  pay,  $300,000  for  the  going  value.  This 
was  a  rate  case.    The  court  said : 

"That  there  is  an  element  of  value  in  an  assembled  and 
established  plant,  doing  business  and  earning  money,  over 
one  not  thus  advanced,  is  self-evident.  Tliis  element  of 
value  is  a  property  right,  and  should  be  considered  in  deter- 
mining the  value  of  the  property,  upon  which  the  owner  has 
a  right  to  make  a  fair  return  when  the  same  is  privately 
owned  although  dedicated  to  public  use." 

In  the  last  named  case  the  court  approved  a  disallow- 
ance of  the  value,  on  the  reproduction  cost  theory  of 
value,  attached  to  the  mains  of  a  gas  company  by 
reason  of  the  laying  of  pavements  above  the  mains 
subsequently  to  their  installation.  If  "value"  is  the 
objective  of  the  court's  inquiry,  how  is  it  possible  to 
escape  the  conclusion  that  what  is  owned  by  the  com- 
pany is  more  valuable  after  than  before  the  streets  are 
paved?  At  least,  a  seller  of  the  entire  property  would 
be  justified  in  demanding  more  by  reason  of  this  change 
in  the  circumstances  of  the  property,  and  a  buyer 

14 


would  be  disposed  to  pay  more.     Is  this  element  of 
value  any  less  a  property  right  than  going  value? 

"NO   PROPERTY"    IN    GOOD   WILL 

Closely  resembling  certain  elements  of  going  value  is 
good  will.  The  Consolidated  Gas  case  {Willcox  vs. 
Consolidated  Gas  Co.,  212  U.  S.  19)  is  authority  for  the 
rule  that  good  will  does  not  exist  in  the  gas  business, 
nor,  inferentially,  in  other  public  service  businesses. 
How  closely  this  rule  corresponds  with  the  fact,  how- 
ever, is  a  matter  of  some  doubt.  Few  of  the  utilities  are 
entirely  free  from  the  influence  of  competing  agencies 
of  some  sort,  even  though  not  of  the  same  kind.  The 
jitney  bus  recently  blossomed  into  a  formidable  com- 
petitor of  the  street  railway  in  the  local  transportation 
field.  The  steam  railroads  are  openly  competitive  as 
between  themselves  in  more  ways  than  one.  Gas  and 
electricity  are  competing  agencies  for  many  kinds  of 
lighting,  heating  and  power  services.  But  whatever 
may  be  the  practical  experience  as  to  the  likelihood  of 
customers  of  these  utiUties  continuing  to  resort  to  the 
old  stand,  the  holding  is  generally  accepted  as  sound 
that  no  property  right  of  good  will  is  acquired  by  a 
public  utihty  enterprise,  which  right  may  be  asserted 
under  the  14th  Amendment  to  stay  the  hand  of  public 
rate  or  service  regulation.  The  rule  here  is  not  that 
no  value  attaches  to  an  acknowledged  property  right, 
but  that  the  property  itself  does  not  exist.  But  this 
does  not  mean  that,  as  between  a  public  utility  and  a 
party  other  than  the  state,  no  property  right  of  good 
will  exists. 

The  valuation  of  franchises  requires  only  brief  men- 
tion in  passing.  He  is  indeed  credulous  who  cherishes 
a  hope  that  the  Supreme  Court  will  ever  find  "value 
for  rate  making"  in  special  franchises.  Yet  franchises 
are  property.  They  are  capable  of  exclusive  possession 
and  use,  and  they  may  be  disposed  of  freely,  subject  only 
to  the  conditions  contained  in  the  franchises  themselves. 
Is  the  refusal  of  the  court  to  require  the  separate 
appraisal  of  the  value  of  such  franchises  in  rate  making 
anything  more  or  less  than  an  adjudication  that  the 
property  right  of  enjoyment  in  franchises  is  a  limited 
one  as  between  the  corporation  and  the  state? 

PROPERTY;  RIGHT  OR  WRONG? 

The  doctrine  was  laid  down  in  the  Knoxville  water 
case  (Knoxville  vs.  Knoxville  Water  Co.,  212  U.  S.  1), 
and  later  specifically  applied  in  the  Minnesota  Rate 
case  (Simpson  vs.  Shepard,  230  U.  S.  352),  that  physical 
properties  must  be  valued  in  their  actual,  depreciated 
condition.  In  the  latter  case  it  was  held  that  land  for 
rights  of  way  and  terminals  may  not  be  taken  at  their 
values  for  railroad  purposes  but  at  their  fair,  market 
values.     Each  of  these  holdings  does  some  violence  to 


210 


THE      UTILITIES      MAGAZINE 


the  repeated  declaration  of  the  court  that  the  object 
of  the  inquiry  is  to  ascertain  fair,  present  value.  Only 
in  a  limited  sense  is  fair,  present  value  affected  by  use 
or  depreciation.  Railroad  property  cannot  well  be 
conceived  of  as  having  anything  other  than  a  value  for 
railroad  purposes.  Here  again,  the  rulings  of  the  court 
are  suggestive  of  an  adjudication  of  the  property  right 
of  enjoyment  in  the  plant  and  equipment,  or  land, 
owned,  rather  than  of  the  value  of  the  exclusive  rights 
of  the  owner  in  such  properties. 

The  14th  Amendment  does  not  mention  value.  It 
extends  the  protection  of  the  Constitution  to  property. 
The  provisions  of  the  amendment  in  point  are  as 
follows: 

"Nor  shall  any  state  deprive  any  person  of  life,  liberty  or 
property  without  due  process  of  law,  nor  deny  to  any  person 
within  its  jurisdiction  the  equal  protection  of  the  laws." 

Blackstone  says  of  property:  "The  third  absolute 
right,  inherent  in  every  Englishman,  is  that  of  prop- 
erty: which  consists  in  the  free  use,  enjoyment,  and 
disposal  of  all  his  acquisitions,  without  any  control  or 
diminution,  save  only  by  the  laws  of  the  land."  1  Bl. 
Comm.  138. 

Property  denotes  rights,  in  its  primary  meaning. 
It  is  in  its  secondary  sense  that  it  denotes  things. 

"In  its  proper  use,  the  term  'property'  applies  only  to  the 
rights  of  the  owner  in  the  thing  possessed.  The  term,  how- 
ever, often  means  the  thing  possessed,  as  well  as  the  estate 
or  interest  which  the  party  possessing  it  may  have  in  it." 
23  Am.  and  Eng.  Ency.  of  Law,  2d  Ed.,  261. 

VALUE  IMPLIED   EXCLUSIVENESS 

The  law  also  recognizes  Umited  properties  in  chattels. 
Of  such  a  nature  is  the  property  of  a  bailee.  And 
property  in  things  material,  even  including  land,  may 
be  limited  by  contract,  gift,  or  devise  or  bequest. 

Of  value,  definitions  are  manifold.  All  definitions, 
however,  seem  to  describe  attributes  of  property. 
Whether  value  has  its  origin  in  the  relation  between 
supply  and  demand,  in  the  labor  expended  in  the 
production  of  a  thing,  or  in  the  cost  of  reproduction 
of  the  thing,  is  relatively  immaterial.  Value,  in  an 
economic  and  a  legal  sense,  seems  incapable  of  existing 
independently  of  an  exclusive  right  of  some  kind. 
The  ultimate  worth  of  a  right  may  depend  on  the 
quahty  of  the  right;  but  the  quaUty  is  not  affected 
by  the  value  attached  to  the  right.  In  searching  for 
value,  or  ultimate  worth,  one's  judgment  may  be 
influenced  as  well  by  some  limitation  of  the  right  itself 
as  by  any  of  the  elements  by  which  value  is  ordinarily 
determined;  either  influence  will  be  discerned  in  the 
result  and  unless  one  distinguishes  closely,  that  may 
be  taken  for  an  effect  which  in  reality  is  a  cause. 


Thus,  diminution  or  aggrandizement  of  right  may 
affect  the  ultimate  worth  fully  as  much  as  inclusion  or 
exclusion  of  elements  of  value. 

RIGHT  OF   DISPOSAL   LIMITED 

Rights  of  property  in  things  devoted  to  public  use 
are  limited  in  at  least  two  different  respects.  First,  is 
enjoyment,  which  is  said  to  be  hmited  to  a  fair  return  on 
value.  Second,  is  disposal,  which  seems  Umited  by 
the  obhgation  to  serve  the  public.  Is  there  an  analogy 
between  the  two  limitations  which  throws  any  light 
on  value? 

Pubhc  service  corporations  labor  under  a  disability  to 
dispose  of  their  property  without  the  sanction  and 
approval  of  the  state.  The  leading  case  in  which  this 
disabiUty  is  set  forth  is  Central  Transportation  Co.  vs. 
Pullman's  Palace  Car  Co.,  139  U.  S.  24.  This  was  an 
action  to  recover  the  stipulated  rental  due  under  a 
lease  of  all  the  personal  property  of  the  plaintiff  to 
the  defendant.  The  defense  was  interposed  that  the 
making  of  the  lease  was  beyond  the  power  of  the 
plaintiff.  The  plaintiff  was  incorporated,  among  other 
things,  for  the  purpose  of  "the  transportation  of 
passengers,  in  railroad  cars  constructed  and  to  be 
owned  by  the  said  company  in  accordance  with  the 
several  letters  patent."  In  the  absence  of  express 
legislative  authority  for  the  company  to  make  the 
lease,  the  court  found  the  lease  to  be  absolutely  void, 
"because  it  involved  an  abandonment  by  the  plaintiff 
of  its  duty  to  the  public."  The  court  based  its  decision 
squarely  on  the  pubhc  duties  assumed  by  the  company. 
It  said : 

"The  plaintiff,  therefore,  was  not  an  ordinary  manufactur- 
ing corporation,  such  as  might,  like  a  partnership  or  an 
individual  engaged  in  manufactures,  sell  or  lease  all  its 
property  to  another  corporation But  the  pur- 
pose of  its  incorporation,  as  defined  in  its  charter,  and 
recognized  and  confirmed  by  the  legislature,  being  the  trans- 
portation of  passengers,  the  plaintiff  exercised  a  public  em- 
ployment, and  was  changed  with  the  duty  of  accommodating 
the  pubhc  in  the  Une  of  that  employment,  exactly  correspond- 
ing to  the  duty  which  a  railroad  corporation  or  a  steamboat 
company,  as  a  carrier  of  passengers,  owes  to  the  public 
independently  of  possessing  any  right  of  eminent  domain. 
.  .  .  .  The  plaintiff  was  not  a  strictly  private,  but  a 
quasi  pubhc,  corporation;  and  it  must  be  so  treated  as 
regards  the  validity  of  any  attempt  on  its  part  to  absolve 
itself  from  the  performance  of  those  duties  to  the  pubhc, 
the  performance  of  which  by  the  corporation  itself  was  the 
remuneration  that  it  was  required  by  law  to  make  to  the 
public  in  return  for  the  grant  of  its  franchise." 

STATE    LAWS    PREVENT   FREE    DISPOSAL 

In  pursuance,  apparently,  of  the  line  of  authorities 
represented  by  this  case,  the  legislatures  of  a  number 


CONSTITUTIONAL    PROTECTION    IN    VALUATION 


211 


of  states  have  enacted  that  public  utiUties  shall  not 
dispose  of  any  part  of  their  property  used  for  the 
convenience  of  the  public  without  first  securing  the 
approval  of  a  public  service  commission.  For  instance, 
the  Illinois  public  utility  law  provides  (Section  27) : 

"Unless  the  consent  and  approval  of  the  Commission  is 
first  obtained:  (c)  no  public  utility  may  assign,  transfer, 
lease,  mortgage,  sell,  or  otherwise  dispose  of  or  encumber  the 
whole  or  any  part  of  its  franchises,  Hcenses,  permits,  plant, 
equipment,  business,  or  other  property;  but  this  shall  not 
be  construed  to  prevent  the  sale,  lease,  assignment  or  transfer 
by  any  public  utiUty  of  any  tangible  personal  property  which 
is  not  necessary  or  useful  in  the  performance  of  its  duties 
to  the  public." 

This  limitation,  furthermore,  is  made  to  apply  to 
natural  persons  engaged  in  a  public  utility  business  as 
well  as  to  corporations.  It  would  seem  to  apply  to  a 
natural  person  owning  an  automobile  and  operating 
it  as  a  jitney. 

Does  such  a  statute  operate  to  deprive  the  owner  of 
his  property  without  due  process  of  law.''  The  right 
freely  to  dispose  of  one's  property  is  one  of  the  rights 
described  by  Blackstone  as  being  inherent  in  every 
Englishman.  Such  rights  are,  of  course,  subject  to 
the  law  of  the  land.  In  the  foregoing  case  of  the 
carrier  of  passengers,  however,  the  right  to  dispose 
of  all  the  personal  property  never  existed.  The  lease 
was  absolutely  void.  Power  in  the  corporation  to 
make  the  lease  was  entirely  wanting.  That  was  not 
a  case  of^the  state,  under  the  police  power,  placing 
a  subsequent  hmitation  on  the  use  of  property.  It 
was  a  case  of  a  corporation,  which  because  it  was  a 
common  carrier  never  came  into  possession  of  rights 
of  property  such  as  another  owner,  not  engaged  in  a 
public  calling,  has  in  the  things  possessed  by  him. 
And  does  it  go  too  far  to  say  that  the  natural  person 
owning  the  jitney  bus  voluntarily  surrendered  the 
right  of  free  disposal  in  his  automobile  when  he  dedi- 
cated that  instrument  of  commorv  carriage  to  public 
use? 

And  if  the  acceptance  of  a  charter  to  engage  in  a 
public  employment  operates  to  prevent  a  corporation 
from  acquiring  a  property  right  of  free  disposal  in  that 
which  it  subjects  to  public  use,  does  the  very  same 
act  operate  to  prevent  the  same  corporation  from 
acquiring  a  complete  property  right  of  enjoyment  in 
the  things  it  comes  to  possess  for  the  convenience  of 
the  public,  even  though  it  is  unable  as  a  result  to  assert 
as  against  the  state  a  value  under  the  14th  Amendment 
which  clearly  would  attach  to  its  plant,  equipment  and 
business  were  it  engaged  in  a  private  calling? 

If  the  owner  of  property  dedicated  to  the  use  of  the 
public  surrenders  in  the  act  of  dedication  his  right 
freely  to  dispose  of  his  property,  does  he  also  surrender 


his  right  to  set  up  the  fair  value  of  his  property  as  a 
barrier  under  the  14th  Amendment  to  legislative  rate 
making,  when  such  right  is  predicated  solely  on  his 
title,  ownership  or  possession?  The  act  of  dedication 
creates  an  obligation  to  serve;  it  also  creates  an  obliga- 
tion to  make  reasonable  charges,  whether  with  or 
without  public  supervision.  If  the  rights  of  ownership 
are  limited  in  the  one  case  are  they  limited  equally  in 
the  other?  Does  the  act  of  dedication  amount  to  a 
waiver  of  the  right  of  exclusive  enjoyment  and  sub- 
stitute in  its  place  for  the  protection  of  the  owner  of  the 
property  a  contract  right? 

The  distinction  in  law  between  public  employment 
and  private  employment  is  now  clearly  defined  and 
generally  well  recognized.  Wyman  (Public  Service 
Corporations,  Sect.  38)  has  illustrated  the  distinction 
by  his  characterization  of  the  duties  imposed  on  each, 
respectively,  by  law.  Thus,  duties  imposed  on  persons 
engaged  in  private  undertakings  are  negative  and 
merely  restrictive;  those  imposed  on  public  undertak- 
ings are  aflfirmative  and  coercive.  To  the  latter,  the 
law  says,  "You  must";  to  the  former,  it  says,  "You 
must  not."  Furthermore,  this  distinction  is  not  a 
creation  of  statute;  it  has  its  origin  in  the  common 
law  and  is  centuries  old. 

PUBLIC  CALLINGS  DISTINGUISHED 

The  distinction  is  well  illustrated  by  an  extract 
from  a  recent  decision'of  a|United  States  Circuit  Court 
of  Appeals  which  appeared  in  an  editorial  in  the 
Philadelphia  Inquirer  of  this  date.  The  decision  was 
that  the  manufacturer  of  a  branded  breakfast  food 
might  lawfully  decline  to  sell  his  product  to  a  retailer 
who  refused  to  maintain  prices.  The  extract  is  as 
follows : 

"  '  We  have  not  reached  the  stage  where  the  selection  of  a 
trader's  customers  is  made  for  him  by  the  government. 
.  .  .  .  We  had  supposed  that  it  was  elementary  law 
that  a  trader  could  buy  from  whom  he  pleased  and  sell  to 
whom  he  pleased  and  that  his  selection  of  seller  and  buyer 
was  wholly  his  own  concern.  It  is  part  of  a  man's  civil  rights 
that  he  is  at  liberty  to  refuse  business  relations  with  any 
person  whomsoever,  whether  the  refusal  rests  upon  reason 
or  is  the  result  of  whim,  caprice,  prejudice  or  maUce." 

"This,  however,  will  be  sad  news  to  those  people  who 
imagine  that  the  government  ought  to  do  everything, 
especially  those  things  which  inhere  to  their  own  benefit." 

A  man  or  corporation  engaged  in  a  public  utility 
business,  however,  has  no  right  of  selecting  his  cus- 
tomers. On  the  contrary,  he  is  compelled  by  his 
profession  to  make  the  entire  public  his  customers. 

In  the  eyes  of  the  law  the  duties  of  a  public  calling 
are  voluntarily  assumed.  Without  a  profession  to 
serve  the  public  the  extraordinary  duties  of  a  public 


212 


THE      UTILITIES      MAGAZINE 


employment  do  not  and  can  not.  attach  to  a  person. 
With  respect  to  corporations  whose  charters  are  silent 
as  to  the  imposition  of  the  duties  of  public  employment, 
the  courts  have  held  that  "by  accepting  the  act  of 
incorporation  they  undertake  to  do  all  the  public 
duties  required."     Lumbard  vs.  Stearns,  4  Cush.  61. 

"It  is  now  well-accepted  doctrine  that  the  very  acceptance 
of  a  charter  providing  for  the  carrying  on  of  a  business  public 
in  character  is  a  sufficient  profession  in  the  particular  case." 
Wyman,  Pub.  Ser.  Corp.,  Sect.  212. 

We  have  already  observed  in  an  earlier  quotation 
how  the  assumption  of  public  duties  is  regarded  as 
consideration  for  the  grant  of  a  charter  to  a  public 
service  corporation. 

"PERSON"  INCLUDES  CORPORATIONS 

The  protection  of  the  14th  Amendment  is  extended 
equally  to  every  "  person."  Public  service  corporations 
are  held  to  come  within  the  meaning  of  "person." 
In  Smythe  vs.  Ames,  169  U.  S.  468,  the  court  said: 
"That  corporations  are  persons  within  the  meaning 
of  this  amendment  is  now  settled."  Three  earlier 
decisions  were  cited  as  authorities.  The  first  of  these 
was  decided  in  the  lower  court  on  the  ground  that  the 
act  of  the  state  legislature  violated  the  provisions  of 
the  14th  Amendment.  The  Supreme  Court,  however, 
found  another  ground  for  deciding  the  appeal,  and 
this  particular  question  of  constitutional  law  was 
not  passed  on,  although  the  court  said  the  importance 
of  the  question  could  not  be  overestimated.  Santa 
Clara  County  vs.  Southern  Pac.  R.  Co.,  118  U.  S.  394. 
Furthermore,  this  was  a  tax  case. 

The  second  authority  cited  was  C.  C.  &  A.  R.  vs. 
Gibbes,  142  U.  S.  386.  Here  the  court  examined  the 
legality  of  a  state  law  which  taxed  railroads  to  defray 
the  cost  of  a  railroad  commission.  With  absolutely 
no  discussion  the  court  said  here:  "Private  corporations 
are  persons  within  the  meaning  of  this  amendment; 
it  has  been  so  held  in  several  cases  by  this  court." 
Of  the  authorities  cited,  the  first  was  the  Santa  Clara 
case,  already  referred  to.  The  second  involved  the 
legality  of  a  license  fee  imposed  on  all  foreign  corpora- 
tions by  the  state  of  Pennsylvania.  Pembina,  etc.  Co. 
vs.  Pennsylvania,  125  U.  S.  181.  The  third  and  last 
involved  the  legality  of  a  statute  assessing  double 
damages  on  railroads  for  live  stock  injured  or  killed  for 
want  of  fences  along  rights  of  way.  M.  &  St.  L.  R.  Co. 
vs.  Beckwith,  118  U.  S.  394. 

The  third  case  cited  in  the  opinion  in  Smythe  vs. 
Ames  was  Gulf,  etc.,  R.  Co.  vs.  Ellis,  165  U.  S.  150. 
This  involved  the  legality  of  a  statute  allowing  the 
collection  of  an  attorney's  fee  by  a  successful  plaintiff 
in  certain  actions  against  railroads.  The  cases  hereto- 
fore described  were  referred  to  as  authorities  for  the 


proposition  that  corporations  are  persons.  In  addition 
were  cited  if.  &  St.  L.  R.  Co.  vs.  Herrick,  127  U.  S.  210, 
which  involved  a  statute  abrogating  the  fellow-servant 
doctrine,  and  Covington  &  Lexington  T.  R.  Co.  vs. 
Sandford,  164  U.  S.  578,  a  case  of  state  rate  making 
in  which  the  application  of  the  14th  Amendment  to 
quasi-public  corporations,  as  opposed  to  merely  private 
corporations,  was  not  referred  to. 

CONSIDERATION  BY  SUPREME  COURT 

Thus  the  Supreme  Court  seems  not  to  have  consid- 
ered whether  the  application  of  the  14th  Amendment 
to  public  service  corporations  involves  any  unusual 
features  growing  out  of  the  voluntary  profession  of 
the  "persons"  there  invoking  protection  to  serve 
the  public  at  reasonable  rates,  as  well  as  out  of  the 
implied  contract  so  to  do  embodied  in  the  granting 
and  acceptance  of  the  corporate  charter.  Nor  does  the 
court  seem  to  have  been  called  on  to  consider  directly 
whether  the  property  right  of  enjoyment  of  a  public 
service  corporation  is  limited  either  by  its  voluntary 
profession  or  by  its  contract  with  the  state. 

In  Western  Advanced  Rate  Case,  1911,  the  Inter- 
state Commerce  Commission  said  (20 1.  C.  C.  R.  307) : 

"Notwithstanding  these  decisions,  it  remains  for  the 
Supreme  Court  yet  to  decide  that  a  public  agency,  such  as  a 
railroad  created  by  public  authority,  vested  with  government 
authority,  may  continously  increase  its  rates  in  proportion 
to  the  increase  in  its  value,  either  (1)  because  of  betterments 
which  it  has  made  out  of  income,  or  (2)  because  of  the  growth 
of  the  property  in  value  due  to  the  increase  in  value  of  the 
land  which  the  company  owns." 

The  Haverhill  Gas  Light  Co.,  with  an  authorized 
capital  stock  of  $75,000  in  1871,  on  which  average 
dividends  of  8  per  cent  per  annum  were  paid,  had  accu- 
mulated in  1900  a  surplus  invested  in  its  plant  and  equip- 
ment estimated  to  represent  from  $275,000  to  $300,000. 
Speaking  of  this  surplus  the  Massachusetts  Board  of 
Gas  and  Electric  Light  Commissioners  said  (16  Annual 
Report  9) : 

"Such  a  surplus  is  by  every  principle  of  law  the  property 
of  the  corporation.  It  has  an  undoubted  legal  right  to 
distribute  it  as  a  dividend  as  it  is  acquired,  or  -pro  rata  to  its 
shareholders  in  case  of  liquidation;  but,  notwithstanding  this, 
the  circumstances  attending  its  accumulation  impose  upon 
the  company,  so  long  as  it  continues  to  exercise  the  functions 
of  a  public  monopoly,  the  duty  to  employ  it  for  the  joint 
advantage  of  the  consumers  and  the  corporation.  It  need 
not  be  dealt  with  as  the  exclusive  property  of  either." 

INVESTMENT  NO  MEASURE   OF  VALUE 

How  do  the  views  expressed  in  the  foregoing  quota- 
tions square  with  the  fair,  present  value  rule?  Is 
there  any  certainty  that  the  Supreme   Court  would 


CONSTITUTIONAL  PROTECTION  IN  VALUATION 


213 


decline  to  sustain  results  obtained  under  the  strict 
application  of  these  views?  But  investment  is  not 
indicative  of  value.  If  it  enters  the  equation  at  all 
under  the  Constitution  it  would  seem  to  be  as  a 
measure  of  subsisting  property  rights  of  enjoyment. 
Neither  commission  would  question  the  right  of  the 
companies  to  possess  and  use  properties  acquired 
from  surplus,  or  properties,  such  as  land,  which  have 
increased  in  value  as  a  result  of  general  community 
growth.  But  the  companies  are  not  at  liberty,  without 
legislative  approval,  to  dispose  of  such  properties, 
thereby  realizing  for  the  benefit  of  their  stockliolders 
the  values  existing  therein.  Are  they  at  liberty  to 
assert  such  values  in  a  proceeding  under  the  14th 
Amendment  to  defeat  rates  which  will  permit  a  reason- 
able return  to  be  earned  on  property  rights  measured 
by  investment  alone? 

The  rule  by  which  the  Massachusetts  Public  Service 
Commission  proposes  to  be  guided  in  fixing  reasonable 
rates  is  thus  stated  in  a  recent  case  {In  re  Blue  Hill 
Street  R.  Co.,  P.  U.  R.  1915  E,  396) : 

"  The  ruling  of  the  Commission  in  the  Middlesex  &  Boston 
Rate  Case,  it  may  be  said,  amounts  simply  to  a  determination 
that  in  this  commonwealth,  at  least,  'fair  value'  may  justly 
be  measured  by  the  amount  of  'capital  honestly  and  pru- 
dently invested,*  rather  than  by  the  cost  of  reproducing  the 
property." 

And  the  Commission  quote  with  approval  the  follow- 
ing extract  from  the  Buffalo  Gas  Case,  3  P.  S.  C.  R. 
(2d.  Dist.  N.  Y.)  353,  644: 

"The  foregoing  considerations  point  with  almost  irresistible 
force  to  the  conclusion  that  what  is  called  the  fixing  of  the 
value  of  the  property  in  the  public  service  for  the  purpose 
of  rate  making  is  not  a  fixing  of  value  in  any  proper  sense 
of  that  word  as  it  is  correctly  used  in  our  language.  It  is 
a  determination  of  what,  under  all  the  facts  and  circumstances 
of  the  case,  is  a  just  and  equitable  amount  upon  which  the 
return  allowed  to  the  corporation  is  to  be  computed." 

LITERAL  OR  FIGURATIVE  MEANING? 

The  rule  announced  by  the  Massachusetts  Commis- 
sion does  violence  to  the  fair,  present  value  rule. 
Would  the  Supreme  Court,  however,  set  aside  a 
schedule  of  rates  fixed  by  the  Commission  and  predi- 
cated on  capital  honestly  and  prudently  invested,  even 
though  the  fair,  present  value  of  the  property  largely 
exceeded  the  amount  of  such  investment?  Justice 
Hughes  in  summarizing  the  law  in  the  Minnesota 
Rate  Case  said : 

"  In  determining  whether  the  right  has  been  denied,  each 
case  must  rest  upon  its  special  facts.  But  the  general 
principles  which  are  applicable  in  a  case  of  this  character 
have  been  set  forth  in  the  decisions. 


"(1)  The  basis  of  the  calculation  is  the  'fair  value  of  the 
property'  used  for  the  convenience  of  the  public 

"  (2)  The  ascertainment  of  that  value  is  not  controlled  by 
artificial  rules.  It  is  not  a  matter  of  formulas,  but  there 
must  be  a  reasonable  judgment,  having  its  basis  in  a  proper 
consideration  of  all  relevant  facts." 

And  the  learned  justice  proceeded  to  quote  the  well 
known  rule  of  Smythe  vs.  Ames  in  which  the  inquiry 
into  value  is  described. 

Is  the  Supreme  Court  using  the  term  "value"  in  a 
literal  sense?  Or  is  the  word  used  figuratively  to 
describe  the  measurement  of  rights  of  property  as 
affected  by  the  profession  of  public  employment  or  by 
the  contract  with  the  state? 

In  the  second  franchise  value  decision  of  the  New 
Jersey  Court  of  Errors  and  Appeals  {Public  Service 
Gas  Co.  vs.  Board  of  Public  Utility  Commissioners, 
94  Atl.  634),  the  contention  was  made  that  the  special 
franchises  of  the  company  had  a  value  for  rate  making 
measured  by  the  difference  between  the  appraised 
value  of  the  physical  properties  and  the  market  value 
of  outstanding  stocks  and  bonds.  The  court  inquired 
into  the  source  of  the  value  alleged  thus  to  exist.  It 
conceded  that  the  franchises  were  property.  But  it 
held  that  their  value  had  its  origin  and  source  in 
unreasonably  high  rates  which  the  state  had  suffered 
the  company  to  charge  in  the  past.  Therefore,  the 
franchises  could  not  properly  be  valued  in  determining 
the  reasonableness  of  rates  to  be  charged  in  the  future. 
The  court  seems  to  have  based  its  judgment  squarely 
on  the  charter  obligation  of  the  company  to  charge 
reasonable  rates  at  all  times,  regardless  of  the  exercise 
by  the  state  of  its  regulating  powers. 

VALUE  AFFECTED  BY  ORIGIN 

This  is  a  case  which  under  other  circumstances  would 
deserve  more  extended  discussion  and  analysis. 
SuflBce  it  now  to  say  that  it  affords  the  somewhat 
novel  principle  that  the  present  value  of  property  may 
be  disregarded  if  the  circumstances  under  which  that 
value  came  to  attach  to  the  property  indicate  a  violation 
in  the  past  of  the  company's  charter  obligation  to 
charge  only  reasonable  rates.  This,  however,  amounts 
to  an  out  and  out  adjudication  of  the  exclusiveness  of 
the  company's  property  rights  of  enjoyment  when  the 
state  is  involved.  Is  this  doctrine  so  hostile  to  the 
rule  of  fair,  present  value  as  to  forecast  its  upsetting 
when  it  is  presented  to  the  Supreme  Court  for  review? 

The  Supreme  Court  has  given  a  clear-cut  intimation 
that  it  sees  a  connection  between  the  charter  contract, 
or  profession  of  public  employment,  of  the  public 
service  corporation  and  valuations  under  the  14th 
Amendment.  In  the  Cedar  Rapids  Gas  Case,  223 
U.  S.  655,  the  court  was  considering  the  failure  of  the 


214 


THE      UTILITIES      MAGAZINE 


regulating  body  to  make  a  specific  allowance  for  going 
value.     It  said : 

"An  adjustment  of  this  sort  under  a  power  to  regulate 
rates  has  to  steer  between  Scylla  and  Chary bdis.  On  the  one 
side,  if  the  franchise  is  taken  to  mean  that  the  most  profitable 
return  that  could  be  got,  free  from  competition,  is  protected 
by  the  14th  Amendment,  then  the  power  to  regulate  is  null. 
On  the  other  hand,  if  the  power  to  regulate  withdraws  the 
protection  of  the  Amendment  altogether,  then  the  property 
is  nought.  This  is  not  a  matter  of  economic  theory,  but 
of  fair  interpretation  of  a  bargain.  Neither  extreme  can 
have  been  meant.  A  midway  between  them  must  be 
meant." 

VALUE  AFFECTED  BY  CONTRACT 

Is  this  a  departure  from  the  fair,  present  value  rule? 
Does  it  suggest  placing  the  adjustment  under  the  14th 
Amendment  on  a  different  basis  from  value  alone? 
Certainly  a  prior  bargain  can  not  affect  present  value 
in  any  proper  sense.  Its  result  might  be,  however,  to 
affect  the  property  rights  that  are  capable  of  assertion 
under  the  law  against  one  party  to  the  bargain  by 
the  other  party. 

In  the  Minnesota  Rate  Case  the  Supreme  Court  had 
before  it  the  contention  that  the  value  of  the  property 
was  affected  by  the  source  from  which  the  property 
was  derived.  This  contention  it  declined  to  consider, 
saying: 

"Finding  this  defect  in  the  proof,  it  is  not  necessary  to 
consider  the  objections  which  relate  to  the  sources  from 
which  the  property  was  derived  or  its  mode  of  acquisition 
.  .  .  .  ;  and  we  express  no  opinion  on  the  merits  of 
these  contentions." 

But  inay  value  in  any  proper  sense  be  measured  by 
the  sources  from  which  the  property  was  derived  or  its 
mode  of  acquisition?  Nevertheless,  the  court  expresses 
no  indisposition  in  a  proper  case  to  consider  these 
objections  on  their  merits.  Is  this  an  indication  that 
the  court  is  coming  to  view  "value"  as  typifying  the 
exclusiveness  of  the  property  rights  of  enjoyment 
acquired  under  a  profession  of  public  service  and  a 
contract  with  the  state  to  charge  only  reasonable 
rates,  whether  the  regulating  power  of  the  state  is 
exercised  or  not? 

It  is  only  within  comparatively  recent  years  that  the 
effort  has  been  made  to  fix  individual  rates  on  the 
basis  of  the  cost  of  the  service.  Prior  to  this  time 
rate  reasonableness  seemed  to  signify  accommodation  of 
the  price  to  the  value  of  the  service  to  the  consumer. 
Canada  So.  R.  R.  Co.  vs.  International  Bridge  Co., 
L.  R.  8  App.  Cas.  723.  In  the  field  of  the  municipal 
utilities,  in  particular,  value  of  service  is  no  longer 
regarded  as  a  dependable  criterion  of  rate  reasonable- 
ness.    With   the   development    of    conditions    which 


required  the  abandonment  of  the  value  of  the  service 
as  a  measure  of  rate  reasonableness,  has  there  arisen 
a  condition  that  precludes  dependence  on  value  as  an 
attribute  of  exclusive  property  rights  to  measure  the 
responsibility  of  the  state  under  the  14th  Amendment? 

SCOPE  OF  EVIDENCE  ENLARGED 

If  the  issue  under  the  14th  Amendment  becomes  the 
exclusiveness  of  the  property  rights  of  enjoyment  of  a 
public  service  corporation  when  the  state  is  involved, 
the  door  apparently  will  be  opened  to  the  introduction 
of  a  considerable  range  of  evidence,  which  under  a 
strict  theory  of  value  would  necessarily  be  excluded. 
It  would  seem  that  the  corporate  and  investment  history 
of  the  company  straightway  would  become  material 
and  relevant  to  the  principal  issue.  There  would 
seem  to  be  occasion  to  show  in  detail  the  circumstances 
under  which  each  step  in  the  development  of  the 
property  was  undertaken,  so  far  as  this  might  be 
possible  with  the  records  that  are  available.  A  demand 
would  seem  likely  to  exist  for  a  practicable  means  of 
measuring  the  risks  of  an  enterprise  during  the  suc- 
cessive stages  of  its  development,  as  these  risks  have 
been  evaluated  by  the  markets  from  which  the  financial 
resources  have  been  drawn. 

The  14th  Amendment  creates  no  property  rights. 
It  simply  prevents  invasion  by  the  state  of  property 
rights  which  are  vested  under  general  law.  There  is 
no  property  right  in  things  dedicated  to  public  use 
which  is  entirely  exclusive.  Rate  and  service  regula- 
tions necessarily  imply  some  limitation  of  the  right  of 
free  enjoyment.  The  very  question  under  the  14th 
Amendment  would  seem  to  be  the  extent  of  that 
limitation.  The  value  of  the  rights  as  so  found  to  be 
limited  is  a  matter  for  subsequent  determination. 
The  limitation  is  voluntarily  assumed  by  the  corpora- 
tion, being  a  matter  of  contract. 

The  14th  Amendment  applies  only  to  invasions  of 
property  rights  by  the  state.  But  the  state  is  one  of 
the  contracting  parties.  How  can  it  be  said  that  the 
state  is  invading  a  property  right  if  it  is  merely  asserting 
that  which  is  secured  to  it  by  contract?  The  contract 
defines  the  quality  of  the  property  rights.  In  advance 
of  a  delimitation  of  the  property  rights  it  is  futile  to 
attempt  to  value  them  in  any  ordinary  sense.  If  the 
ascertainment  of  value  is  in  reality  the  delimitation  of 
property  rights,  then  the  only  essential  issue  is  the 
meaning  of  the  contract. 

VALUES  AS  INTERPRETATION  OF  CONTRACT 

We  have  regarded  value  as  an  external  attribute  of 
property  rights.  If  value  be  regarded  as  something 
inherent  in  the  very  conception  of  property,  its  existence 
in  rate  making  is  measured  entirely  by  the  exclusiveness 


CONSTUTITIONAL  PROTECTION  IN  VALUATION 


215 


of  the  right  of  enjoyment.  Then  the  value  of  property 
in  a  constitutional  sense  in  rate  making  must  depend 
on  the  contractual  right  of  the  corporation  to  exclude 
the  state  from  interfering  with  earnings.  In  either 
view  of  value,  it  cannot  be  measured  without  a  prior 
determination  of  the  bounds  of  exclusiveness  of  the 
owner's  rights  of  enjoyment  as  against  the  state. 

The  question  of  value,  then,  seems  to  come  to  one  of 
the  interpretation  of  a  contract.     Broadly  speaking, 


value  may  be  taken  as  an  expression  of  the  intention 
of  the  parties  to  a  contract,  as  such  intention  is  derived 
from  the  contract  itself  and  the  subsequent  conduct 
of  the  parties.  This  view  of  value  is  not  far  removed 
from  the  results  reached  by  the  Supreme  Court  to 
date.  It  is  one  that  will  go  a  great  ways  to  harmonize 
on  a  common  ground  of  principle,  if  not  of  fact,  the 
several  interests  touching  rate  making  under  legislative 
authority. 


DISCUSSION  OF  CONSTITUTIONAL  PROTECTION  IN  VALUATION 

By   Newton   D.    Baker 

Mayor  of  Cleveland 


The  Fourteenth  Amendment  to  the  Constitution  provides 

"nor  shall  any  state  deprive  any  person  of  life,  liberty  or 
property  without  due  process  of  law." 

This  prohibition  upon  the  action  of  the  states  is  enforceable 
by  the  courts,  and  the  Supreme  Court  of  the  United  States 
is  the  guardian  of  whatever  protection  is  here  guaranteed. 
Its  terms  are  simple  and  comprehensive.  No  state  can 
deprive  any  citizen  of  property.  It  is  not  necessary  in  this 
connection  to  discuss  the  due  process  limitation,  nor  is  it 
necessary  to  refer  to  the  similar  provisions  of  state  constitu- 
tions, for  to  the  extent  that  they  are  less  sweeping  than  this 
guarantee,  they  are  supplemented  by  it. 

In  the  application  of  this  provision  to  the  property  of 
public  utUity  companies  we  have  several  difficulties  to  con- 
tend with.  Obviously  the  inquiry  in  each  case  is:  What 
is  the  extent  of  the  property?  And  this  inquiry  is  complicated 
since,  first,  the  mere  devotion  of  property  to  a  public  use  is 
a  dedication  to  the  public  of  some  part  of  the  proprietary 
right;  second,  the  police  powers  of  the  state  cannot  be  abridged 
by  contract;  and  third,  the  property  of  utilities  is  operated 
under  a  vast  variety  of  state  laws  and  ordinances,  some  of 
them  creating  quite  explicit  contracts,  and  some  of  them  so 
indefinite  on  the  contractual  side  that  rather  violent  implica- 
tions are  necessary  to  develop  any  contractual  relation  at 
all.  It  is  doubtless  this  variety  of  relationships  which  led 
Mr.  Justice  Hughes  to  say,  in  the  Minnesota  Rate  case 
quoted  by  Mr.  Kern,  that 

"in  determining  whether  the  right  has  been  denied,  each 
case  must  rest  upon  its  special  facts." 

THE  PARENT  DECISION 

In  1876  the  Supreme  Court  of  the  United  States,  in  Munn 
vs.  Illinois,  laid  down  the  doctrine  that 

"when  the  owner  of  property  devotes  it  to  a  use  in  which 
the  public  has  an  interest,  he  in  efl^ect  grants  to  the  public 
an  interest  in  such  use  and  must,  to  the  extent  of  that  interest, 
submit  to  be  controlled  by  the  public  for  the  common  good 
as  long  as  he  maintains  the  use. " 

This  doctrine,  concurred  in  by  Chief  Justice  Waite,  Justices 
Clifford,    Miller,    Bradley,    Swain,    Davis   and   Hunt,   was 


vigorously  dissented  from  by  Mr.  Justice  Field  and  Mr. 
Justice  Strong,  the  point  of  their  dissent  being  that  any 
implied  dedication  to  the  public  of  an  interest  in  private 
property  by  such  devotion  of  the  property  to  a  public  use, 
was  merely  a  roundabout  way  of  defeating  the  operation  of 
the  protection  guaranteed  by  the  Fourteenth  Amendment. 
But  from  the  date  of  the  decision  of  that  case  until  now,  the 
doctrine  has  stood  and  has  been  repeatedly  affirmed.  The 
implications  of  the  doctrine  have  constantly  widened  and 
as  rate  regulation  has  grown  in  the  country,  this  starting 
point  has  developed  greater  importance.  Of  course,  it  still 
leaves  undetermined  the  extent  of  the  interest  dedicated  to 
the  public  and  that  must  be  determined  first,  in  order  to 
separate  it  from  the  property  still  remaining  in  the  company 
which  is  the  property  to  be  valued. 

WHAT  IS  DEDICATION  TO  THE  PUBLIC 

Perhaps  the  doctrine  underlying  this  separation  could  be 
stated  as  follows:  the  devotion  of  certain  property  to  the 
public  service  in  a  public  utility  enterprise  admits  the  public 
to  such  an  interest  in  the  property  as  will  enable  the  public 
to  exercise  the  control  necessary  to  prevent  conditions  more 
adverse  to  the  public  interest  in  the  operation  of  the  prop- 
erty than  could  be  secured  were  the  public  free  to  contract 
with  others.  In  this  we  have  a  rule,  both  for  a  separation 
of  the  property  remaining  in  the  owners  from  that  donated 
to  the  public  and  for  a  valuation,  which  will  be  difficult  to 
follow  only  because  of  the  variant  conditions  in  individual 
cases.  That  rule  would  be  that  when  a  company  engages 
in  a  public  utility  service  it  retains  the  right  to  operate  its 
property  only  upon  the  basis  of  valuation  and  in  the  mode 
of  operation  which  it  could  do  in  a  fair  competitive  field,  and 
as  a  consequence  it  donates  to  the  public  whatever  rights  or 
value  inhere  in  the  fact  that  either  its  franchise  or  the  public 
convenience  exclude  actual  competition. 

Under  such  a  rule  as  this  many  rights  and  investments  do 
not  cease  to  be  property,  but  they  must  cease  to  be  the 
property  of  the  owning  company  or  individual  by  being  a 
part  of  the  donation  to  the  public.  As  a  matter  of  fact 
some  such  theory  as  this  will  ultimately  have  to  prevail  and 
prevent  recourse  by  the  public  to  municipal  ownership  as  a 


216 


THE      UTILITIES      MAGAZINE 


relief  from  the  inclusion  of  elements  into  valuation  for  rate 
making  purposes  upon  which  the  public  are  unwilling  to  pay. 
We  must  never  forget  that  our  theoretical  and  legal  logic- 
chopping  about  propositions  of  this  kind  will  be  corrected 
for  us  by  a  stern  application  of  the  practical  facts  as  they 
occur  in  the  world.  The  utility  experts  may  spin  as  fine 
theories  as  they  choose,  but  when  the  price  gets  too  high  the 
public  will  decline  to  pay  just  as  they  did  in  the  Knoxville 
Water  case,  where,  having  granted  an  exclusive  franchise, 
or  at  least  bound  the  city  of  Knoxville  to  make  no  grant  in 
conflict,  the  city  itself  undertook  to  perform  the  service  and 
its  detour  was  sustained. 

The  difficulties  that  arise,  in  determining  the  property  of  a 
company,  from  the  character  of  contracts  made  under 
particular  state  laws  and  city  ordinances,  are  of  course  just 
what  Mr.  Prouty  calls  it:  more  an  interpretation  of  a  contract 
than  a  determination  of  a  value.  If  a  city  has  granted  to  a 
street  railroad  company  the  right  to  build  and  operate  a 
street  railroad  under  definite  terms  and  conditions  and  to 
charge  a  stipulated  rate  of  fare  for  a  definite  period  of  years, 
that  contract  cannot  be  impaired  by  the  action  of  the  state, 
and  any  attempt  at  regulation  of  the  rate  is  obviously  in- 
hibited by  another  provision  of  the  Federal  Constitution. 
But  street  railroad  contracts  and  other  public  utility  con- 
tracts thus  definite  in  their  terms  do  not  come  into  courts  on 
regulation  questions.  It  is  where  the  term  is  indefinite  or 
the  rate  required  to  be  reasonable,  or  some  other  elastic  pro- 
vision exists  in  the  contract,  that  the  courts  are  called  upon. 
We  therefore  have  two  kinds  of  questions:  first,  the  settle- 
ment of  the  meaning  of  the  contract,  when  that  is  done  the 
respective  and  relative  rights  of  the  public  and  the  owners 
are  determined;  and  second,  the  valuation  question  then 
arises  upon  the  rights  thus  apportioned  to  the  owners  as 
against  the  public. 

METHODS  OF  VALUATION 

I  shall  not  here  enter  upon  the  various  theories  of  valuation. 
Each  of  them  is  beset  by  difficulty,  because  the  thing  to  be 
valued  cannot  have  a  market  price.  Of  course  the  securities 
of  a  utility  company  can  be  sold  in  the  market,  but  the  value 
attached  in  the  market  to  those  securities  attaches  to  the 
property  of  the  pubhc  and  of  the  corporation  alike.  One 
element  in  that  market  valuation  is  undoubtedly  the  nuisance 
value  of  the  property  or  the  inconvenience  to  which  the 
pubUc  would  be  subjected  in  any  attempt  to  restrict  the 
corporation  to  a  return  upon  its  own  rights  properly  segre- 
gated and  valued.  The  market  price  also  includes  some- 
thing, for  the  fact  that  the  action  of  the  public  in  the  assertion 
of  its  rights  is  spasmodic,  and  particular  spasms  of  assertion 
are  discounted  by  the  market  anticipation  of  corresponding 
spasms  of  feebleness  and  discouragement  on  the  part  of  the 


public.  The  market  price  also  values  exceedingly  temporary 
things,  like  managerial  skill,  which  may  die  in  a  day  with  a 
particular  genius,  or  be  disrupted  in  a  few  weeks  by  serious 
labor  disputes.  This  market  value  disregards  the  hazards 
of  the  art  in  response  to  a  perfectly  general  disposition  on  the 
part  of  men  to  regard  a  particular  state  of  mechanical  art  as 
permanent,  and  to  accept  an  advance  in  the  art  as  either  an 
unforeseeable  calamity,  or,  at  best,  a  benefit  to  which  an 
existing  corporation  has  such  superiority  of  access  as  to 
enable  it  to  protect  itself  from  complete  destruction. 

In  particular  cases  of  valuation  the  problem  is  further 
complicated  by  sentimental  considerations.  The  attitude 
which  a  public  ser^'ice  company  has  taken  toward  the  people 
enormously  affects  the  value  of  its  property.  Two  corpora- 
tions in  the  same  service,  with  the  same  opportunities  and 
with  physical  property  of  identical  character,  the  one  having 
the  motto  "The  pubhc  be  damned"  and  the  other  "The 
public  be  pleased,"  will  have  a  wholly  different  value.  A 
company  which  has  maintained  a  mysterious  process  of 
concealment  about  its  earnings  or  has  earned  and  distributed 
extravagant  dividends  will  probably  be  regarded  as  having 
enjoyed  its  fat  years  and  be  properly  a  candidate  for  its  lean 
ones,  while  exactly  a  similar  company,  which  is  not  suspected 
of  having  been  prosperous,  but  is  known  to  have  had  a 
struggle  and  not  to  have  distributed  more  than  just  returns 
upon  its  investment,  will  find  it  easy  to  secure  from  public 
officers,  with  the  approval  of  the  public  to  be  served,  a 
generous  attitude  toward  the  valuation  of  its  property  and 
the  adjustment  of  its  rates. 

Attempts  on  the  part  of  companies  to  include  fantastic 
items  and  to  add  to  actual  physical  values  extravagant  per- 
centages for  omitted  property,  and  for  undefined  and  indef- 
inite items  of  overhead,  irritate  both  the  public  and  their 
representatives,  so  that  the  problem  of  making  a  particular 
valuation  is  never  free  from  diSicult  legal  questions,  distorting 
historical  associations  and  sentimental  elements  which  preju- 
dice any  attempt  at  a  white  light  determination  of  value. 

And  yet  the  process  is  in  all  likelihood  simplifying  daily, 
and  the  relation  of  the  Supreme  Court  to  such  valuations, 
when  made,  is  clarifying  with  each  decision.  State  and  local 
tribunals  to  which  the  power  to  determine  the  facts  is  com- 
mitted will  not  be  interfered  with  unless  their  determination 
is  clearly  confiscation  on  the  instalment  plan.  The  devotion 
of  property  to  a  pubhc  use  will  gradually  be  recognized  as  a 
dedication  to  the  public  of  a  property  interest  in  all  the  non- 
competitive advantages  of  public  utility  operation,  and  our 
efforts  at  valuation  will  finally  result  in  a  determination  of 
the  value  of  property  assembled  and  in  operation,  excluding 
non-competitive  advantages,  and  the  values  so  fixed  will  be 
protected  under  the  Fourteenth  Amendment  as  the  property 
of  the  owners  of  the  utility. 


CONSTITUTIONAL    PROTECTION    IN    VALUATION 


217 


DISCUSSION  OF  PAPERS  BY  HON.  CHARLES  A.  PROUTY  AND  MR.  WM.  D.  KERR 
ON  "THE  MEANING  OF  CONSTITUTIONAL  PROTECTION  IN  VALUATION" 

By  a.  L.  Valentine 

Superintendent  of  Public  Utilities,  Seattle,  Wash. 


I  have  read  the  able  paper  of  the  Hon.  Charles  A.  Prouty 
on  "The  Meaning  of  the  Constitutional  Protection  in 
Valuation"  with  approbation  and  have  devoted  to  Mr. 
Kerr's  interesting  and  complete  paper  on  the  subject  a 
measure  of  earnest  thought. 

Mr.  Kerr  devotes  no  attention  to  the  fact  that  when  the 
question  as  to  whether  or  not  certain  contested  elements  of 
public  utility  properties  have  "value,"  has  been  finally 
determined,  the  result  will  in  but  small  degree  only  affect 
"rates." 

As  an  extreme  example,  were  the  courts  to  decide  that 
the  great  street  railway  transportation  system  in  Mr.  Kerr's 
own  city  had  absolutely  no  "value"  either  for  money  actually 
invested,  unearned  increment  of  real  estate  values  or  surplus 
accruing  from  efficient  operation,  that  finding  could  be 
reflected  in  a  reduction  of  only  approximately  2.5  per  cent 
in  the  service  "rate."  While,  were  the  courts  to  decide 
only  that  contested  elements  of  public  utility  properties 
had  no  "value,"  that  finding  could  only  be  reflected  in  a 
"rate"  reduction  of  negligible  percentage. 

Rates  for  service  of  public  utility  properties  are,  therefore, 
subject  only  to  slight  variation  by  judicial  decision.  They 
are  affected  in  major  degree  by  operating  charges  and 
conditions  which,  in  my  judgment,  being  administrative, 
will  never  be  determined  by  the  courts.  To  be  properly 
determined  by  regulatory  bodies  it  will  be  necessary  to 
have  experts  of  national  reputation  at  the  service  of  such 
bodies  to  point  out  operating  efficiencies  and  economies. 

That  the  Supreme  Court,  however,  will  finally  and  fully 
pass  upon  the  matters  of  franchise  values,  good  will,  "un- 
earned increment,"  surplus  accruing  from  efficient  operation 
which,  as  I  indicated,  affect  only  in  slight  degree  the  service 


"rate,"  within  a  generation,  is  hardly  to  be  expected  and 
is  a  matter  which,  in  my  judgment,  will,  because  of  the 
greater  effect  of  operating  economies  upon  rates,  have  lost 
the  slight  importance  it  now  has  long  before  that  time. 

When  a  corporation  pays  taxes  for  governmental  pur- 
poses and  thus  assists  in  the  maintenance  of  law  and  order, 
allows  of  educational  facilities  and  aids  in  the  development 
of  commercial  and  industrial  conditions  and  opportunities 
in  so  far  as  they  are  dependent  upon  governmental  co- 
ordination and  supervision,  all  of  which  elements  tended 
to  create  value,  that  corporation  performed  a  duty  to  the 
community  over  and  above  its  duty  as  a  public  service 
corporation  to  give  good  service  at  reasonable  rates. 

This  fulfilled  duty,  in  my  judgment,  entitles  corporations 
to  the  same  benefit  as  accrued  to  any  individual  or  "person" 
who  paid  taxes  on  real  estate  in  proportion  to  the  value  which 
he  and  other  taxpayers  created. 

"Unearned  increment"  has  been  hurled  at  this  extra 
value,  which  in  our  country,  properties  both  of  corporations 
and  of  individuals  possess,  over  and  above  that  "value" 
it  has  in  revolution-swept  American  countries,  and  large 
numbers  of  our  people  use  the  expression  quite  glibly. 

To  come  back  to  the  discussion.  I  would  conclude 
with  the  statement  that  I  cannot  comprehend  how,  by  any 
process  of  reasoning,  the  Supreme  Court  of  the  United  States 
could  eventually  arrive  at  a  decision  that  "values"  corpor- 
ations assist  in  creating  by  the  performance  of  duties  over 
and  above  their  public  duties,  whether  that  help  was  rendered 
in  the  payment  of  taxes  or  in  the  exercise  of  resourcefulness, 
skill  and  foresight  beyond  the  ordinary,  should  not  be  allowed 
to  those  corporations. 


218 


THE      UTILITIES      MAGAZINE 


VALUATION  AND  THE  FUTURE  OF  PUBLIC  UTILITIES 


By  Milo  R.  Maltbie 

Former  Public  Service  Commissioner,  New  York  City;  Member  of  Advisory  Board  to  the  Division  of  Valuation  of  the  Interstate  Commerce  Commission 

THERE   are   four   principal   directions   in   which 
valuations  may  be  used: — capitalization,  taxa- 
tion,   purchase    and    rate    making.     Probably 
less  use  has  been  made  of  valuations  in  connection  with 


capitalization  than  in  any  other  direction;  but  if  records 
of  actual  cost  are  wanting,  and  if  capitalization  is  to 
have  a  relation  to  property,  a  valuation  is  about  the 
only  standard  that  can  be  used.  Obviously  earnings, 
which  may  be  used  as  a  principal  factor  in  determining 
the  relation  of  bonds  to  stocks, 
are  not  satisfactory;  for  they  are 
too  fluctuating,  and  capitaliza- 
tion may  not  be  expanded  and 
contracted  as  earnings  go  up 
and  down.  Further,  if  earnings 
depend  largely  upon  rates,  and 
rates  upon  valuation,  it  would 
be  more  logical  to  use  the  ulti- 
mate factor  and  base  capitaliza- 
tion upon  valuation. 

Let  no  one  misunderstand. 
I  do  not  now  contend  that  a 
valuation  should  fix  capitaliza- 
tion where  the  original  cost  of 
the  existing  property  is  known, 
or  that  securities  now  out- 
standing should  be  increased 
or  reduced  to  correspond  to  a 
valuation;  but  it  may  be  used, 
and  doubtless  will  be  in  the 
future,  to  assist  in  determining 

whether  additional  securities  should  be  authorized. 
Even  where  original  cost  is  known,  a  survey  of 
the  property  is  a  useful  guide  to  the  financial  sound- 
ness of  a  utility.  Indeed,  it  would  probably  be  as 
unsafe  for  a  public  service  corporation  to  neglect 
periodic  surveys  as  it  would  for  a  grocer  to  fail  to  in- 
ventory his  goods  occasionally.  If  all  additions  and 
betterments  are  properly  charged  to  plant  and  property 
account  and  if  all  withdrawals  and  retirements  are 
properly  credited,  the  capitalization  of  a  company  must 
of  necessity  reflect  the  cost  of  the  existing  property. 
But  as  a  matter  of  fact,  this  is  seldom  done  with  exact- 
ness. Additions  appear  in  operating  expenses,  or 
withdrawals  are  not  reported  to  the  accounting  depart- 
ment; and  the  book  accounts  as  a  result  do  not  reflect 
what  actually  exists.  An  occasional  appraisal  is, 
therefore,  often  necessary  to  show  the  extent  of  the 
discrepancies,  provided  always  that  the  valuation  is 


along  sound  lines  and  not  prepared  to  bolster  a  pre- 
conceived notion  or  to  aid  some  financial  coup.  Valua- 
tions should  reflect  actual  conditions;  yet  they  may  be 
made  to  distort  the  facts,  just  as  easily  as  a  miiTor  may 
be  so  shaped  as  to  reflect  grotesque  figures  which  do 
not  exist  outside  of  the  imagination. 


PART  XIII 

VALUATION  AND  THE  FUTURE 
OF  PUBLIC  UTILITIES 


"It  is  not  uncommon  also  for  utilities  to  forget 
the  effect  of  their  claims  upon  the  public  and  to 
drive  the  application  of  a  rule  to  the  extreme. 
They  have  not  hesitated  to  demand  their  pound  of 
flesh,  little  realizing  that  by  so  doing  they  may,  in 
the  long  run,  lose  that  to  which  they  may  be  justly 
entitled.  Public  opinion  gathers  momentum  slowly 
and  often  fails  to  reach  those  responsible  for  un- 
wise action,  but,  when  once  aroused,  it  often  sweeps 
on  resistlessly  and  a  corporation  which  by  its  un- 
just and  unreasoning  demands  has  forfeited  public 
confidence  often  reaps  the  whirlwind.  .  .  .  Public 
confidence  is  one  of  the  greatest  assets  which  any 
corporation  may  have,  and  those  who  destroy  it 
through  their  extravagant  claims  in  valuation  mat- 
ters must  face  a  responsibility  which  many  would 
not  care  to  assiune." 


VALUATIONS  FOR  TAXATION 

The  use  of  valuations  for  taxation  purposes  is  prob- 
ably the  oldest  and  best  known. 
But  as  there  is  the  greatest  va- 
riety in  laws  and  methods,  it  is 
seldom  that  valuations  made 
for  rate  making  purposes  may 
be  used  without  many  adjust- 
ments for  taxation;  and  when 
earnings,  net  or  gross,  are  the 
basis  of  assessment,  it  is  only 
very  indirectly  that  valuations 
are  of  any  utility.  Ordinarily, 
the  appraisals  of  land  and 
buildings  will  be  consulted  by 
assessors,  and  where  a  company 
has  been  representing  that  these 
have  a  low  value  and  to  the  rate 
making  authority  that  they  are 
very  valuable,  it  will  find  its 
position  untenable. 

The  general  trend  will  be 
towards  an  increase  in  assess- 
ments and  in  the  amount  of 
taxes  paid.  Momentarily,  this  may  mean  a  decrease 
in  net  earnings,  assuming  other  factors  remain  sta- 
tionary. But  when  an  adjustment  has  been  reached 
in  all  directions,  the  public  utility  will  collect  the  added 
taxes  from  the  users  of  its  service,  for  the  rates  must 
be  sufficiently  high  to  enable  the  utility  to  pay  all 
expenses,  including  taxes,  and  still  leave  a  fair  return 
upon  the  fair  value  of  its  property.  So  far  as  the  in- 
crease in  taxes  represents  a  more  equitable  distribution 
of  the  cost  of  government,  this  readjustment  is  proper 
and  desirable;  but  to  the  extent  that  it  represents  a 
shifting  of  burdens  from  the  general  property  owner  to 
the  users  of  utilities  merely  because  it  is  easy  or  may 
be  accomplished  without  general  opposition,  it  is  im- 
proper and  unjust.  The  tax  that  may  be  collected 
with  the  least  squawking  is  not  necessarily  the  one 
doing  the  least  injustice. 


VALUATION    AND    FUTURE    OF    PUBLIC    UTILITIES 


219 


CONDEMNATION  OR  PURCHASE 

The  appraisal  of  utilities  in  connection  with  condem- 
nation proceedings,  franchise  grants  and  purchase  by 
agreement  has  also  been  very  common.  The  munici- 
palization of  water  works  has  been  productive  of  many 
valuations,  and  the  earlier  court  decisions  upon  ap- 
praisal questions  have  related  thereto.  However, 
franchise  conditions  have  often  determined  the  general 
line  of  the  inquiry,  and  even  in  condemnation  cases  the 
capitalization  of  net  earnings  has  been  such  an  im- 
portant factor  that  an  inventory  and  appraisal  has  not 
had  the  significance  which  has  later  been  attached  to  it 
in  rate  cases. 

The  courts  have  not  infrequently  pointed  out  that 
there  is  a  difference  between  condemnation  proceedings 
and  rate  making.  Doubtless  this  is  true  in  certain 
directions,  but  it  must  become  apparent  that,  as 
public  regulation  becomes  more  effective  and  vigilant, 
the  two  must  approach  a  common  basis.  Where  rates 
have  been  brought  down  to  a  fair  return  upon  fair 
value,  even  the  rule  that  authorizes  a  capitalization  of 
net  earnings  would  produce  the  fair  value  upon  which 
the  rates  have  been  fixed.  Wliere  the  price  is  fixed 
before  the  rates  are  reduced,  it  is  obvious  that  a  capi- 
talization of  earnings  will  justify  an  amount  in  excess  of 
the  fair  value  fixed  in  a  rate  case.  Hence,  if  public 
authorities  are  watchful  and  never  allow  rates  to  get 
beyond  a  fair  return,  valuations  in  condemnation 
proceedings  must  approach,  if  not  actually  coincide 
with,  valuations  in  rate  cases.  It  follows  that  con- 
demnation proceedings  should  not  be  brought,  if  the 
price  paid  is  to  be  kept  to  a  minimum,  before  the  reason- 
ableness of  the  rates  charged  has  been  determined, 
wherever  the  courts  consider  the  capitalization  of  net 
earnings  as  a  factor.  It  also  follows  that  as  regulation 
becomes  more  efficient,  the  importance  of  valuations 
for  rate  purposes  increases. 

These  observations  apply  with  special  force  to  the 
work  now  being  done  by  the  Interstate  Commerce 
Commission  under  the  Valuation  Act  of  1913.  In  the 
recent  rate  advance  cases,  the  Commission  has  con- 
fessed its  inability  to  decide  whether  rates  were  too 
high  in  relation  to  the  value  of  the  property  because 
it  had  no  satisfactory  evidence  of  value.  It  had, 
therefore,  to  adopt  other  standards,  more  or  less  un- 
satisfactory, because  they  were  substitutes  and  approxi- 
mations. 

Now  it  is  clearly  apparent  that,  whether  the  first 
issue  arising  after  the  railroad  valuations  have  been 
completed  relates  to  rates  or  to  purchase,  the  fair  values 
to  be  found  will  be  decisive  of  both.  Further,  the 
country  will  know  for  the  first  time  the  approximate 
cost  of  government  purchase  and  of  constructing  a  few 


through  lines  as  advocated  by  certain  persons  who  seem 
to  have  lost  faith  in  the  success  of  public  regulation. 
If  those  valuations  will  determine  the  basis  of  purchase 
and  rates,  they  will  naturally  greatly  affect  the  values 
of  securities  when  there  is  a  great  discrepancy  between 
the  valuation  and  the  capitalization. 

RATE  MAKING 

The  most  important  and  general  use  now  being  made 
of  valuations  is  for  rate  making  purposes,  and  fre- 
quently it  is  assumed  that  all  other  factors  are  unim- 
portant. However,  it  is  the  rate  charged  the  public 
that  is  of  ultimate  interest,  and  in  reaching  this  goal, 
many  other  factors  are  considered.  For  example,  the 
stockholder  receives  the  same  dividends  whether  the 
rate  making  authority  allows  a  return  of  5  per  cent  on  a 
value  of  $1,500,000  or  7§  per  cent  on  $1,000,000,  and, 
for  the  moment,  the  consumer  does  not  care  which 
course  is  followed  if  only  the  total  gross  allowance  to 
investors  is  limited  to  $75,000.  But  operating  expenses 
and  allowances  for  depreciation  must  be  considered; 
and  if  the  company  must  provide  for  retirements, 
renewals  and  ultimate  replacement  of  the  property 
upon  the  basis  of  a  value  of  $1,500,000,  the  annual 
depreciation  charge  must  inevitably  be  larger  than 
if  the  property  has  a  value  of  only  $1,000,000.  A 
larger  depreciation  allowance  means  a  larger  total 
expense  and  a  larger  total  expense  means  higher  rates. 
Or,  if  it  be  stated  conversely,  under  fixed  rates  the  net  \ 
return  would  be  smaller  and  there  would  not  be  suffi-  ) 
cient  net  earnings  to  pay  the  total  return  to  capital  of  ^ 
$75,000. 

But  whatever  importance  may  attach  to  other 
factors,  it  is  certain  that  the  future  of  public  utilities 
and  the  attitude  of  the  public  towards  utilities  under 
private  management  will  depend  in  large  measure 
upon  the  principles  followed  in  determining  fair  value. 
Perhaps  this  may  best  be  indicated  by  a  few  concrete 
illustrations. 

It  is  contended  in  certain  quarters  that  it  does  not 
matter  whether  the  public  has  given  a  private  corpora- 
tion a  large  part  of  its  property  or  whether  the  corpora- 
tion has  been  obliged  to  purchase  all  of  it,  and  that  ' 
a  company  is  entitled  to  a  fair  return  upon  all  property 
which  it  owns  or  uses,  even  though  a  large  portion  may 
have  been  given  to  it  by  public  authorities  or  the  users 
of  its  service  to  induce  it  to  operate.  This  contention 
is  not  limited  to  physical  property  but  covers  franchises, 
permits  and  other  grants  whereby  the  public  may  have 
permitted  a  corporation  to  use  streets,  highways  or 
public  places. 

For  the  purposes  of  this  discussion,  it  is  unnecessary 
to  decide  whether  these  contentions  are  correct.     I 


220 


THE      UTILITIES      MAGAZINE 


simply  wish  to  point  out  at  this  time  that  a  ruling 
upon  these  contentions  will  have  an  important  bearing 
upon  the  future  of  all  utilities.  If  commissions,  legis- 
latures and  courts  decide  that  public  service  corpora- 
tions may  legally  require  the  public  to  pay  rates  suffi- 
ciently high  to  yield  a  return,  not  only  upon  the  actual 
investment  in  the  enterprise,  but  upon  property,  tang- 
ible and  intangible,  which  the  public  has  donated, 
everyone  will  forthwith  proceed  to  ask  himself  whether 
it  is  just  and  whether  a  similar  course  shall  be  followed 
in  the  future.  Will  not  the  public  decide  that  under 
such  circumstances  it  were  better  that  no  aid  should 
be  given  to  corporations,  or,  if  aid  is  necessary,  that 
the  public  itself  should  control  and  manage  its  own 
utilities?  Will  it  not  be  said  that  hereafter  a  corpora- 
tion must  agree  that  it  will  not  enforce  against  a  be- 
nevolent public  a  right  which  the  public  believes  to  be 
unjust  and  inequitable?  Is  it  reasonable  to  assume 
that  if  the  country  had  in  the  past  realized  that  its  own 
generosity  would  be  turned  against  it  and  made  the 
basis  for  higher  charges  indefinitely,  it  would  have 
made  the  grants  or  donations  which  have  been  made  so 
frequently?  Would  not  the  public  rather  have  in- 
sisted that  everything  be  paid  for  and  nothing  be  given? 

APPRECIATION   IN   LAND    VALUES 

Probably  no  single  factor  is  of  greater  importance  in 
the  valuation  of  railroads  than  land.  It  is  contended 
that  in  determining  the  fair  value  of  railroad  property 
the  cost  of  land  or  rights  of  way  is  irrelevant  and  imma- 
terial except  to  show  how  much  more  must  be  paid  than 
the  value  of  the  land  itself,  and  that  present  values  shall 
be  conclusive,  upon  the  basis  of  the  present  value  of 
adjoining  land  plus  all  expenses  which  the  carrier 
would  be  obliged  to  pay  if  it  were  to  acquire  by  con- 
demnation its  present  right  of  way.  The  process  does 
not  contemplate  that  the  entire  influence  of  the  railroads 
shall  be  removed  and  that  the  value  of  the  land  shall  be 
estimated  as  if  all  railroads  in  the  vicinity  were  not  in 
existence;  but  it  builds  up  an  estimated  value  upon  the 
assumption  that  the  existing  railroads  are  still  there 
and  another  railroad  is  to  be  built  in  the  immediate 
vicinity.  There  are  many,  of  course,  who  claim  this 
method  is  not  only  illegal  but  unjust,  in  that  it  makes 
the  public  pay  upon  a  value  which  the  public  itself  has 
created;  and  it  is  asserted  that  the  method  is  illogical 
because  it  assumes  a  railroad  not  to  be  in  existence 
and  yet  takes  as  a  basis  land  values  which  would  not 
exist  if  the  railroad  were  not  there. 

However,  I  am  not  for  the  moment  concerned  with 
the  justice  or  injustice  of  the  plan.  I  merely  wish  to 
point  out  at  this  time  that  if  the  public  must  pay, 
through  the  rates  charged,  all  losses  due  to  wear,  decay 
and  disappearance  of  physical  property,  if  the  public 


must  stand  all  shrinkage  in  values  due  to  the  deprecia- 
tion of  property,  and  may  not  share  in  gains  due  to  the 
appreciation  of  property,  and  must  in  addition  pay  a 
return  upon  such  appreciation,  all  will  pause  to  con- 
sider whether  private  ownership  and  operation  of 
public  utilities  is  not  so  unfair  and  burdensome  under 
such  a  ruling  that  communities  cannot  afford  to  allow 
its  utilities  to  get  into  private  hands.  On  the  other 
hand,  if  honest,  wise  and  economical  investment  be 
made  the  basis  bf  rates,  and  if  the  public  may  acquire 
utilities  at  any  time  upon  the  basis  of  a  valuation  which 
treats  appreciation  upon  the  one  hand  just  as  it  treats 
depreciation  upon  the  other,  may  not  many  communities 
prefer  private  management,  knowing  that  their  rates 
will  have  a  reasonable  relationship  to  an  equitable 
basis  and  that  an  unbearable  burden  will  not  be  im- 
posed upon  any  community  which  attempts  to  supply 
communal  needs  through  community  action? 

DEPRECIATION 

Some  of  the  most  diflBcult  problems  in  valuation  work 
arise  in  connection  with  depreciation.  This  subject 
has  two  important  aspects.  In  every  rate  case,  a 
decision  must  be  reached  as  to  the  amount  of  accrued 
depreciation  and  the  allowance  for  annual  depreciation 
in  connection  with  operating  expenses.  It  seems  to 
be  generally  conceded,  as  decided  by  the  United  States 
Supreme  Court,  that  physical  property  decreases  in 
value  as  it  is  used  and  that  the  investment  becomes 
impaired  if  no  provision  is  made  year  by  year  to  offset 
this  decrease  and  for  the  ultimate  replacement  of  prop- 
erty. There  are  those,  however,  who  contend  that 
public  utilities  have  a  peculiar  characteristic  which 
distinguishes  them  from  other  property  in  that  they  do 
not  depreciate.  These  persons  often  contend,  further, 
that  while  there  is  no  accrued  depreciation,  annual 
allowances  should  be  made  in  addition  to  maintenance 
and  repairs  for  ultimate  replacements. 

One  might  point  out  the  inevitable  conflict  of  such 
contentions  and  show  how  contrary  they  are  to  every- 
day experience.  But  it  is  not  my  province  to  do  so  here 
and  whether  these  contentions  are  right  or  wrong,  the 
final  decision  will  have  a  direct  bearing  upon  the  future 
of  public  utilities.  Litigants  may  occupy  inconsistent 
positions,  but  courts  and  commissions  must  recognize 
that  the  decision  made  regarding  accrued  depreciation 
must  be  consistent  with  that  relating  to  annual  depre- 
ciation, and  that,  if  there  is  a  constant  diminution  in 
value  from  year  to  year,  provisions  must  be  made  out 
of  earnings  to  offset  this  loss.  As  the  Supreme  Court 
has  said,  investors  are  not  required  to  see  their  property 
decrease  in  value  from  year  to  year  without  recompense, 
but  are  entitled  to  collect  from  the  public  an  amount  to 
offset  such  diminution.    It  follows  that,  if  it  is  finally 


VALUATION   AND    FUTURE    OF    PUBLIC    UTILITIES 


221 


determined  that  property  does  not  decrease  in  value, 
there  is  no  necessity  for  a  fund,  no  need  to  offset  a  loss 
which  does  not  exist.  It  also  follows  that,  if  there 
is  a  decrease  of  10  per  cent  per  annum,  there  must  be 
an  allowance  in  operating  expenses  of  10  per  cent  per 
annum. 

The  public  has  at  times  been  reluctant  to  recognize 
this  principle,  and  partially  because  of  its  unfortunate 
experiences.  Public  authorities  have  permitted  com- 
panies to  accumulate  large  reserves  in  order  to 
safeguard  investors  and  to  guarantee  excellent  and 
constant  service  in  the  future.  The  public  has  con- 
sidered that  these  funds  were  in  the  nature  of  trust 
funds  to  be  held  for  the  service  of  the  public  and  not 
for  the  benefit  of  investors  except  so  far  as  they  were 
actually  needed  to  protect  the  integrity  of  the  invest- 
ment. In  some  instances,  usually  where  new  interests 
have  secured  control  of  the  utilities,  an  attempt  has 
been  made  to  distribute  these  funds  to  stockholders,  or 
in  other  words,  to  cut  a  melon.  The  public,  seeing 
these  funds  disappearing  and  appreciating  that  when 
they  have  once  been  distributed  in  dividends  they  are 
no  longer  available  for  public  use,  have  tried  to  prevent 
their  distribution;  and  in  some  cases  they  have  been 
successful,  in  others  unsuccessful.  The  experience, 
however,  has  convinced  many  that,  if  reserve  funds  are 
to  be  used  in  this  manner  and  are  not  to  be  preserved, 
the  interests  of  consumers  are  in  jeopardy. 

In  my  opinion,  this  situation  is  most  unfortunate. 
Public  utilities  cannot  be  kept  abreast  of  the  times 
without  adequate  and  proper  provision  for  deprecia- 
tion.    Companies  ought  to  have  funds  with  which  to 
replace  property  not  only  when  it  wears  out,  but  when 
it  becomes  inadequate  and  obsolete;  and  no  utility  can 
adequately  serve  the  public  unless  it  is  kept  abreast 
of  the  times,   and  new  inventions  and  methods  are 
adopted  as  soon  as  their  utility  has  been  demonstrated. 
If  a  niggardly  policy  is  adopted  regarding  depreciation, 
the  development  of  utilities  will  be  retarded  and  com- 
munities will  suffer;  but  if  a  generous  policy  is  adopted 
and  if  corporations  treat  these  funds  as  trust  funds, 
the  utility  will  benefit  and  the  community  will  benefit. 
But  it  is  impossible  to  expect  the  public  to  be  generous 
towards  utilities  and  have  their  generosities  or  liberali- 
ties of  policy  turned  against  them  at  a  later  date.     In 
my  opinion,  that  utility  which  opposes  proper  depre- 
ciation funds,  or,  if  allowed  to  accumulate  them,  which 
proceeds  to  use  them  for  other  purposes,  has  not  only 
broken  faith  with  the  public,  but  invited  retaliatory 
methods  which  it  will  be  the  first  to  decry.' 

'  The  maintenance  of  a  proper  depreciation  reserve  does  not  in- 
volve the  hoarding  of  cash  in  the  bank.  It  may,  under  ordinary  condi- 
tions, more  wisely  be  invested  in  property,  such  as  extensions  and 
additions  to  plant. 


INCREASING  PRICES 

Those  interested  in  valuation  work  have  been  im- 
pressed with  the  marked  effect  of  increasing  prices. 
Recent  valuations  of  property  which  has  been  in  exis- 
tence for  a  considerable  period  show  an  estimated  cost 
of  present  reproduction  far  in  excess  of  original  cost. 
This  is  due,  in  large  part,  to  the  change  in  unit  prices 
and  to  the  fact  that  generally  prices  have  increased. 
The  adoption  of  the  principle  that  fair  value  is  based 
upon  present  unit  prices  means  that  today  a  utility  is 
entitled  to  a  considerably  larger  net  profit  than  it 
would  be  if  its  property  were  valued  upon  the  basis  of 
investment   or  original  cost.     It   means   that   stock- 
holders will  obtain  larger  returns,  not  because  of  any 
activity  of  their  own,  but  because  the  general  standard 
of  prices  has  increased.     If  the  increased  production 
of  gold  is  the  cause  of  increasing  prices,    it  means  that 
because  gold  is  now  mined  more  cheaply  and  in  larger 
quantities  than  when  the  utility  was  established,  it  is 
entitled  to  larger  profits.     Whether  this  plan  is  unjust 
is  aside  from  the  question  here,  but  it  is  evident  that  if 
fair  value  is  based  on  contemporary  prices,  stockholders 
will  gain  or  lose  not  according  to  their  investment,  but 
according  to  facts  over  which  they  have  no  control.     In 
a  time  of  rising  prices,  this  principle  will  stimulate  the 
construction  of  utilities;  in  a  period  of  falling  prices,  it 
will    retard    development.     Further,    it    introduces    a 
speculative  element,  for  profits  will  not  depend  upon 
the  efficiency  of  the  management,  but  upon  economic 
conditions    wholly    independent    of    the    enterprise. 
Whatever  may  be  the  merits  of  speculation  in  general 
commodities,  it  has  done  far  more  injury  than  good  in 
public  utilities,  and  many  of  the  evils  which  have  been 
so  vividly  depicted  are  due  not  to  policies  adopted  by 
investors,  who  were  looking  for  a  safe,  conservative 
and   reasonable   return,   but   to   the   manipulators   of 
utilities,  who  depressed  conditions  one  day,  inflated 
them  the  next,  and  then  retired  from  the  field  with 
their  profits,  leaving  to  another  group  the  difficulties 
of  management  under  burdensome  conditions  which 
were  inherited. 

One  might  continue  to  analyze  the  various  phases  of 
valuation  work  and  in  each  case  show  its  effect  upon  the 
future  of  public  utilities.  There  is  scarcely  an  instance 
where  the  decision  of  any  question  will  be  limited  in  its 
effect  to  present  or  past  conditions,  yet  nothing  is  more 
common  than  for  a  corporation  attorney  to  look  only 
to  the  present  and  to  insist  upon  the  adoption  of  rules 
which  will  bring  momentary  advantages. 

It  is  not  uncommon  also  for  utilities  to  forget  the 
effect  of  their  claims  upon  the  public  and  to  drive  the 
application  of  a  rule  to  the  extreme.     They  have  not 


222  THE      UTILITIES      MAGAZINE 

hesitated  to  demand  their  pound  of  flesh,  little  realizing  caught  in  the  storm  who  were  responsible  for  the  deluge, 

that  by  so  doing  they  may,  in  the  long  run,  lose  that  the  result  might  not  be  so  unjust;  but  all  utilities  are 

to  which  they  may  be  justly  entitled.     Public  opinion  apt  to  suffer  for  the  misdeeds  of  a  few  and  it  is  not 

gathers   momentum  slowly  and  often  fails  to  reach  always  possible  to  discriminate  between  good  and  bad. 

those  responsible  for  unwise  action,  but  when  once  Public  confidence  is  one  of  the  greatest  assets  which 

aroused,  it  often  sweeps  on  resistlessly  and  a  corporation  any  corporation  may  have,  and  those  who  destroy  it 

which  by  its  imjust  and   unreasoning  demands   has  through  their  extravagant  claims  in  valuation  matters 

forfeited  public  confidence  often  reaps  the  whirlwind,  must  face  a  responsibility  which  many  would  not  care 

If  the  punishment  fitted  the  crime  and  only  those  were  to  assume.  • 


INDEX 


223 


INDEX 


Accounting:  Depreciation  as  a  factor  in,  110- 

111;  in  original  cost,  20. 
Accounts,  in  original  cost,  45. 
Actual  cost,  20,  37,  45,  51-53,  50,  173,  177,  185. 

See  Historical  Cost. 
Actual  Cost.    Robert  H.  Wliitten,  51-53. 
Adams,  Brooks,  22,  38. 
Agency  theory  (U.S. vs.  Joint  Tariff  Association, 

Takott  vs.  Pine  Grove),  38;  of  utility  valuation, 

22.  88-91. 
Allison,  James  E.     A  Criticism  of  Theoretical 

Depreciation,  124-126.     See  also,  27,  134. 
Alternative  plant  duplication,  24. 
Amortization,  63,  64,  122. 
Anderson,  G.  W.     How  To  Get  Rid  Of  The 

Reproduction  Cost  Theory,  28-36.     See  also 

55,  59. 
Appraisal,  adjustment  in,  130. 

method,  of  valuation,  128. 

Appraisal  Work,  Some  Essentials  of.    F.  W. 

Ballard,  179-181. 
Appreciation,  90-97. 
Approximation,  valuation  by,  183-187. 
Average  prices,  163. 

Baker,  Newton  D.  Constitutional  Protection 
in  Valuation,  215-216. 

Balance  in  reserve,  how  used,  119,  120, 

Baldwin,  De  Forrest,  Henrt.  Determining 
Franchise  Values,  67-71. 

Ballard,  F.  W.  Some  Essentials  of  Appraisal 
Work,  179-181. 

Barker,  Harry.  Making  Depreciation  Discus- 
sion Understood,  131.     See  also,  76,  98, 135. 

Bauer,  John,  100,  127-130,  133,  158-159. 

Bell  Telephone  Company  of  Pennsylvania,  14. 

Bemis,  Edward  W.  Original  Cost  As  The 
Chief  Basb  For  Fair  Value,  36-42.  See  also 
14,  58,  99. 

Berlin  Electric  Light  Company,  original  cost,  41. 

Bettman,  Alfred.  Constitutionality  of  Histori- 
cal Cost  Method  of  Public  Utility  Valuation, 
46-51. 

Bettman,  Alfred.  Theory  of  Franchise  Values, 
74-76. 

Black,  Jeremiah  S.,  88. 

BoNBRiGHT,  James  C,  97. 

Brewer,  Justice,  94. 

Bristol  Water  Works  Case,  65. 

Bristow,  Joseph  L.,  152-153. 

Broad  Street  Terminal  valuation,  87. 

Buffalo  Gas  Case,  28,  39. 

Buildings,  appraised,  183. 

BuRCH,  Edward  P.  Fair  Value  In  Practice, 
64,58. 

Capital,  amortization  of,  122;  investment  of,  168. 

■ — —  cost,  as  basis  for  actual  profits,  53. 

Capitalization,  66,  111,  218;  depreciation,  factor 
in  {People  ex  rel.  liinghamton  Light,  Heat  & 
Power  Company  vs.  Public  Service  Commis- 
sion), 111. 

Capitalizing  deficits  {Superior  Commercial  Club  vs. 
Sup.  W.  L.  &  P.  Co.,  State  Journal  Ptg.  Co.  vs. 
Madison  Gas  &  Elec.  Co.;  In  re  application 
La  Crosse  Gas  &  Electric  Co.),  147. 


Carriers'  contention,  in  valuation,  88. 

Charter  limitations,  32. 

Classification,  175. 

Combination,  6. 

Common  carrier,  land  valuation  of,  88-91. 

Commissions,  reduction  of  lighting  rates,  effected 
by.  24. 

Community  demands,  81. 

Comparative  plant  method,  150. 

Compensation  for  franchises,  62. 

property,  judicial  function,  49. 

Competition,  22,  23.  51.  114.  156,  161. 

Compromise,  utilities  and  public.  25. 

Condemnation,  62,  74,  219. 

and  purchase,  depreciation  factor  in  {New- 

buryport  Water  Co.  vs.  Newburyport;  Kennebec 
Water  District  vs.  WaterviUe),  109. 

Conference  of  Utilities,  importance  of.  4. 

Confiscation,  meaning  of,  47  {See  constitutional 
protection). 

Confiscatory  rates,  30,  31. 

Consolidated  Gas  Case  on  franchise,  61. 

Consolidation,  losses  due  to,  157. 

Constitutional  protection  in  valuation,  46,  48,  50, 
204-2C8. 

Construction  costs,  14,  43-44,  84,  163. 

Consumers'  obligations,  137. 

Contracts,  21,  70;  impairment  of  obligation  of,  32. 

Cooke,  Morris  Llewellyn,  4-5,  188-190. 

Co-operation,  in  inventories,  174,  181. 

in  presenting  facts.  11. 

Cost,  uniformity  in,  170. 

keeping,  165-169,  188. 

of  production,  25,  113. 

of  reproduction  as  basis  for  rate  making, 

151.     (See  Reproduction  theory.) 

—  price  vs.  threat  price,  6. 

theory  4, 11.  (See  also  actual  cost  and  his- 
torical cost.) 

Coiling  vs.  Kansas  City  Stock  Yards  Company, 
80,  50. 

Court,  attitude  on  inaccuracies,  201. 

decisions,  on  depreciation,  102-112;  on  land 

values.  81  (See  List  of  cases) ;  on  original  cost, 
49;  on  rates  and  valuation,  29,  60;  on  value. 
206,  209. 

practice,  76. 

recognition  of  estimates,  187. 

rulings,  defects,  32. 

Covington  and  Lexington  Turnpike  Company  vs. 
Sandford,  47. 

Credit,  control  of,  167;  in  valuation,  31. 

Cross  examination,  judicial  attitude,  202. 

Decisions  reviewed,  145,  146,  147: 

Mayhew  vs.  Kings  Co.  Ltg.  Co. 

Hill  et  al  \s.  Antigo  etc. 

Fuhrmann  vs.  Cataract  Power  and  Conduit 
Company. 

Hobart  Pillsbury  et  al  vs.  Peoples  Gas  Lights 
Company. 

McGregor-Noe  ■rs.  Springfield  Gas  and  Electric 
Company. 

Cedar  Rapids  Water  Co.  vs.  Cedar  Rapids. 

In  re  Rates  of  Queens  Borough  Gas  and  Elec- 
tric Company. 


Dedication  to  public,  215: 
Lincoln  Gas  &  Electric  Light  Co.  vs.  City   of 
Lincoln. 

Deficit,  13,  20,  22,  147-150. 

Demand  and  supply,  162. 

Depreciated  value,  25,  124. 

Depreciation,  4,  32,  41,  43,  44, 100, 103, 110, 132, 
186,  220;  accrued,  117;  actual,  105;  allowance 
for,  from  earnings  {Brymer  vs.  Buder  Water 
Co.),  107;  and  fair  value,  104,  112-124,  116- 
119,  127-130  {See  Fair  Value);  as  a  factor  in 
accounting,  110-111;  as  a  factor  in  ascertain- 
ing net  income,  105-109;  as  a  factor  in 
capitalization.  111;  as  a  factor  in  physical 
valuations  for  basis  of  rate  return,  103-105. 

court  decisions,  102-112. 

sinking  fund,  method  of 

San  Joaquin   &  Kings  R.  C.  d-  /.  Co.  vs. 
Stanislaus,  105. 

defined  {Cumberland  Telephone  and  Tele- 
graph Company  vs.  City  of  Cumberland),  100- 
102,  103,  113,  131;  determination  of,  114-115; 
distribution  of  charges  for,  117;  estimation  of, 
in  advance,  124;  for  replacement,  135;  how 
provided  for,  101,  115,  116;  in  condemnation 
and  purchase  cases,  109;  in  tax  cases,  109-110; 
in  valuation  accounting,  42;  nature  of,  113- 
115;  of  buildings  and  machinery,  186;  of  prop- 
erty. 132;  percentages  for,  137;  proper  charge 
to  operating  expenses,  115;  provision  for.  101, 
115-116;  reproduction  method  and,  52;  re- 
serves, 118,  119,  120;  risk  of,  in  reproduction 
cost,  53;  sinking  fund  method,  101;  theoret- 
ical, a  criticism  of,  124-126;  unmatured,  118. 

Depreciation,  A  Criticism  of  Theoretical. 
James  E.  Allison,  124-126. 

Depreciation  and  Its  Relation  to  the  Fair 
Value.    Halford  Erickson,  112-124. 

Depreciation,  Court  Decisions  on.  Jacob 
H.  Goetz,  102-112. 

Depreciation  Defined.  Frederic  P.  Stearns, 
100-101. 

Des  Moines  Gas  case,  19. 

Detail  in  Inventories,  189.     (See  Inventories.) 

Detroit,  telephone  systems  in,  156. 

Discrepancy  in  land  values,  85. 

District  of  Columbia,  173,  175. 

Dollar,  change  in  value  of,  in  relation  to  valua- 
tion, 191. 

Doty,  Edward  W.  The  Measurement  of  Land 
Values,  85-87. 

Dow  vs.  Beiddman,  30. 

Du  Pont,  A.  B.  Fallacy  of  the  "Reproduction 
Cost"  theory  in  determining  the  value  of 
property  of  public  utilities,  25-27. 

Due  process  of  law,  21.  46.  (See  historical 
method.) 

Duluth.  utility  losses  in,  158. 

Duplication,  9. 

Earnings,  effect  of,  on  value,  26. 
Easement,  in  franchise,  73. 
Eastern  Electric  Development  Company,  origi- 
nal cost,  40,  41. 
Economic  changes,  influence  of,  5,  156. 
wastes,  174. 


224 


THE      UTILITIES      MAGAZINE 


Electric  field,  competition  in,  23. 

Eminent  domain,  effect  on  investments,  73. 

Engineer  on  inventory,  19,  54  (See  Opinion  Tes- 
timony). 

Engineering  opinion,  value  of,  19. 

Equal  protection  of  laws,  47  (See  Historical 
Method). 

Equipment,  life  of,  125. 

Equity  in  reproduction  cost,  19,  155. 

Erickson,  Halford.  Depreciation  and  Its 
Relations  to  the  Fair  Value,  112-124. 

Erickson,  Halford.     Original  Cost,  43-45. 

EsHLEMAN,  John  M.  A  Criticism  of  the  Re- 
production Theory  of  Valuation,  5-12  {See 
also  n,  57,  01-92,  136). 

Estimate  in  valuation,  183  (See  Valuation  by 
Approximation) . 

Ethical  basis  in  value,  54. 

Evidence,  rules  of,  195. 

Excess  returns,  deducted,  128. 

Excessive  profits  on  valuation,  166. 

Exchange  value,  13. 

Exclusiveness  in  franchise,  61-65. 

Expense  in  valuation  cases,  25,  190,  203. 

of  inventory  methods,  189. 

Expert  market,  cornered  by  corporations,  200. 

testimony,  admitted,  196,  in  fair  value,  23. 

Experts:  Biased,  excluded,  197;  interested,  ex- 
cluded, 198;  unwilling  to  testify,  200. 

Exploitation  of  franchise  values,  69. 

Fair  price,  what  it  is,  161. 

return,  19, 20,  21,  22,  23,  24,  34,  36,  71,  73, 

101. 
value,  7,  12,  14,  17,  21,  52,  64,  81,  83,  112, 

114,  116,  151,  213,  219. 
Fair  Value  in  Practice.    Edward  P.  Burch, 

54-58. 
Fall  River  case,  55. 
Farrington,  Judge,  138. 
Financial  Aspects  of  Regulation.    Robert 

C.  Wood,  170-171. 
Financial  Aspects  of  Valuation.    Paul  A. 

Sinsheimer,  165-169. 
Fifth  Amendment,  the,  21. 
Fisher,  Walter  L.,  38. 
Formula  for  present  value  (Kerr),  208. 
Fourteenth  Amendment,  21,  31.  138,  214. 
Fox,  A.  M.     Going  Value  in  Purchase  vs.  Rate 

Cases,  153-154. 
Franchises,  4,  59,  60,  66,  67,  70,  72,  73,  74,  75, 

76,  137,  138,  142,  209. 
Franchise  privileges.  Const,  limitations,  72. 
Franchise  Valuation,  Legal  and  Adminis- 
trative Phases  of,  72-74. 
Franchise    Valuation,    Some    Distinctions 

Between  The  Legal  and  Administrative 

Phases  of.     Chester  A.  McLain,  72-74. 
Franchise  values,  59-67;  Determining  of,  67-71; 

for  capitalization,  66-67;  for  involuntary  sale, 

65-66;  for  purposes  of  condemnation,  62-65; 

for  rate  making,  61-62;  for  taxation,  59-01. 
Franchise  Values,  Determining.    Henry  De 

Forest  Baldwin,  67-71. 
Franchise  Values,  Principles  As  To.     Delos 

F.Wilcox,  59-67. 
Franchise  Values,  Theory  op.     Alfred  Bett- 

man,  74-76. 
Frank,  L.  K.,  133-134. 
Freight  charges,  increase  of,  91. 


French,  H.  Findlat.    Reproduction  Value  vs. 

Fair  Value,  12-17. 
Functional  depreciation  (Det  Moines  Water  Co. 

vs.  City  of  Des  Moines),  105,  108. 
Furniture  and  apparatus,  185. 

Gatton,  Oscar  F.,  58,  133. 

Gifts  to  utilities  taxed,  33. 

Gillette,  Halbert  P.  Discussion  of  Mr. 
Eshleman's  paper  on  "  A  Criticism  of  the  Re- 
duction Theory  of  Valuation,"  22-25  {See 
a/so  38). 

Glaeser,  M.  G.  The  Problem  of  Unit  Prices 
in  Valuation,  161-165. 

Goetz,  Jacob  H.  Court  Decisions  on  Depre- 
ciation, 102-112. 

Going  concern,  15-16, 186. 

value,  15,  37,  70,  134,  138,  141,  142,  144, 

146,  155,  157,  160. 

Going  ualue  and  good  will  {In  re  Publ.  Service 
Gas  Case,  Consolidated  Gas  Case),  139-140; 
decisions  on,  145;  definition  of,  138;  tax  of 
franchise,  70. 

Going  Value  as  an  Element  of  Fair  Value. 
Clifford  Thorne,  138-152. 

Going  Value  in  Purchase  vs.  Rate  Cases. 
A.  M.  Fox,  153-154. 

Good  will,  139,  209  {See  Going  Value). 

Government,  reduction  of  rates  by,  6. 

ownership,  27. 

Grat,  John  H.  Expert  (Or  Opinion)  Testimony 
in  Rate  Valuation  Cases.  A  study  in  the 
Administration  of  Justice,  192-204.  See  also 
28,  40,  55,  192. 

Greed,  effect  of,  199. 

Hadley,A.T.,44. 

Hagenah,  William  J.,  155-158. 

Hale,  Robert  L.,  58,  132,  158,  192. 

Hayes,  Hammond  V.  Principles  to  be  Applied 
in  Valuing  Land,  77-84  {See  also  38,  39). 

Helm,  A.  E.  Principles  to  be  Applied  in  Valua- 
tion of  Lands  Used  for  the  Purpose  of  a  Com- 
mon Carrier,  88-91. 

Historical  cost,  4,  10,  20   {See  also  Actual  Cost). 

Historical  Cost  Method,  Constitutionality 
OF,  OP  PuBUC  Utility  Valuation.  Alfred 
Bettman,  46-51. 

Hughes,  Justice,  16-17. 

Income  property,  96. 

Injudicious  investment  (Gates  &  Hurtley  vs. 
Del.  &  Ad.  Tel.  &  Tel.  Co.),  148. 

Installation  cost,  128-129. 

Intangible  values,  14,  139. 

Interest,  20, 27. 

Interstate  Commerce  Act,  182. 

Commission,  Data  Respecting  Rail- 
roads, 10. 

orders  of,  61. 

Interstate  Com.  Com.  vs.  Union  Pac.  R.  R.,  51. 

Inventories,  Co-operation  in  Making.  R.  J. 
Meigs,  181-182. 

Inventories,  The  Making  and  Maintenance 
OF  Priced.     Charles  L.  Pillsbury,  171-178. 

Inventories;  Detail  in,  175, 189, 190;  estimates  in, 
183,  187;  of  engineers,  54;  making  and  main- 
tenance of,  171-178;  purpose  of,  173,  189. 

Investments,  32, 35, 44^5, 64, 117, 130, 156, 159, 
212. 


Investors  and  the  public,  32,  33. 
Involuntary  sale,  65. 

Job  order  system,  180. 

Judicial  re%aew  on  rates,  51.     {See  "Courts  and 

Constitutional  Protection. ") 

Kansas  City  vs.  National  Waterworks  Co.,  139. 

Kerr,  William  D.     Constitutional  Protection 

m  Valuation,  208-215. 

Kings  Co.  Lighting  Co.  vs.  Willcox,  37,  41. 
Knowles,  Morris.     Relation  of  Reproduction 

Cost  to  Fair  Value,  17-21. 

Labor  costs,  effect  on  reproduction  value,  14. 

Lake  Shore  Railroad,  34. 

Land:  Fair  present  value  of,  83-84;  original 
cost  of,  80. 

Land,  Principles  to  be  Applied  in  Valuing. 
Hammond  V.  Hayes,  77-84. 

Land,  The  Proper  Treatment  of  Apprecia- 
tion OF.     Milo  R.  Maltbie,  96-100. 

Land  valuation:  Inadequacy  of,  86;  of  common 
carrier,  88-91. 

Land  Value,  The  Measurement  op.  Edward 
W.  Doty,  85-87. 

Land  values,  81-83,  220. 

Land  Values  Under  Minnesota  Rate  Case. 
Thomas  D.  O'Brien,  84-85. 

Land  valuing,  principles  in,  77-84,  92-96. 

Lands,  Principles  to  be  Applied  in  Valua- 
tion OF,  Used  for  the  Purpose  of  a  Com- 
mon Carrier.     A.  E.  Helm,  88-91. 

Langmuir,  Dean,  134,  191. 

Legal  vs.  Administration  phases  of  franchise 
valuation,  72-74. 

Legislature  may  regulate,  not  destroy,  205. 

Legislatures  in  rate  making,  34,  201-206. 

(See  Courts,  Judicial  Review,  Constitutional 
Protection.) 

Lighting  rates,  effect  of  regulation.  24. 

Limited  franchise,  64. 

Lloyd,  Morton  G.,  133. 

Losses,  150,  156. 

Lurton,  Justice,  139. 

Machinery  inventory,  184. 

Maltbie,  Milo  R.  The  Proper  Treatment  of 
Appreciation  of  Land,  96-100;  Valuation  and 
the  Future  of  Public  Utilities,  218-222. 

Market  value,  48,  78,  85. 

in  private  property  (Devon  vs.  City  of 

Cincinnati),  48. 

Massachusetts  Public  Service  Act,  34. 

Commission  on  original  cost,  41. 

Mayors'  Conference,  4. 

McKay,  Charles  W.,  160. 

McLain,  Chester  A.  Some  Distinctions  be- 
tween the  Legal  and  Administrative  Phases  of 
Franchise  Valuation,  72-73. 

Meigs,  R.  J.  Co-operation  in  Making  Invento- 
ries, 181-182. 

Middlesex  and  Boston  Rate  Case,  34. 

Minnesota  Rate  Case,  utility  non-existent  im- 
possible to  estimate,  9,  29,  81,  83. 

Minneapolis  Street  Railway  Fare  Case,  62. 

Monopoly,  7,  23,  193. 

Morse,  John  G.  Valuation  by  Approximation, 
183-187.     See  also  192. 

Munn  vs.  Illinois,  Justice  Field,  dissenting 
opinion,  5. 


INDEX 


225 


Negotiations  in  voluntary  purchase,  66. 

Net  income,  depreciation,  a  factor,  105. 
Contra  Costa  Water  Co.  vs.  Oakland. 

Net  earnings:  In  franchise  values,  60;  for  taxa- 
tion, 60. 

sacrifice  theory,  valuation,  127. 

New  Brunswick  Board  of  Commissioners  on  origi- 
nal cost,  40. 

New  Hampshire  Public  Service  Commission  on 
original  cost,  41. 

New  York,  franchise  valuation  in,  60. 

New  York  Commission  First  District  on  original 
cost,  41. 

New  York,  New  Haven  and  Hartford  Railroad: 
Investigation  by  Interstate  Commerce  Com- 
mission into  the  affairs  of,  166;  on  reproduc- 
tion cost,  28. 

New  York,  Tax  Law  in,  69. 

Non-monopolistic  value,  26. 

Normal  competitive  prices,  162. 

cost,  51. 

price,  53. 

return,  52. 

value,  81.  112-113. 

Obligation  of  contracts,  30  {See  Constitutional 

Protection) . 
O'Brien  Thomas  D.    Land  Values  under  the 

Minnesota  Rate  Case,  84-85. 
Operation,  what  constitutes  successful,  143. 
Operating  charges,  against  gross  income  {U.  S. 

vs.  Kansas  Pac.  R.  R.  Co.),  106. 
"expenses,  depreciation  and  renewals,  charged 

to,  115. 
Opinion  as  evidence,  history  of,  196. 
Opinion  Testimony  (or  Expert)  in  Rate  Vai/- 

UATioN  Cases.    John  H.  Gray,  192-204. 
Organization,  174. 

in  reproduction  value,  15. 

Origin  of  reproduction  cost,  29. 

Original  cost,  20,  21,  30^2,  43,  45,  54,  78,  113, 

165-166.     {See  also  Actual  Cost  and  Histori- 
cal Cost.) 

Construction  account  in  actual  cost,  43,  44. 

Difficulties  in,  45. 

Hadley,  A.  T.,  on  original  cost,  44. 

Unit  prices,  45. 

investment,  37. 

Original  Cost.     Halford  Erickson,  43-45. 
Original  Cost  as  the  Chief  Basis  fob  Fair 

Value.     Edward  W.  Bemis,  36-42. 
Overhead  charges,  19,  143,  177. 

Passaic  Gas  Case,  61. 

Paternalism,  effect  on  utilities,  168. 

Pavement,  14. 

Payne  et  al  vs.  Wisconsin  Telephone  Company,  20. 

Peckham,  Justice,  on  land  values,  90. 

Perpetual  franchises,  and  amortization  funds,  63. 

"Person"  includes  corporations,  212: 

Smythe  vs.  Ames;  Santa  Clara  Co.  vs.  S.  P.  R. 

R.  Co.;  C.  C.  &  A.  R.  vs.  Gibbes;  Pembina  etc. 

Co.  vs.  Pennsylvania;  M.  &  St.  L.  R.  Co.  vs. 

Beckwith. 
Philadelphia  Electric  Company,  188. 
Phillips,  James  W.,  179. 
Physical  valuation,  factor  in,  103: 

Peo.  ex.  rel.  Jamaica  Water  Supply  Co.  vs.  Tax 
Comms.; 

Pioneer  Td.  &  Tel.  Co.  vs.  Westenhaver. 


Physical  valuation,  76. 

Physical  value,  59. 

Physical  Value  no  deduction  for  depreciation 
{City  of  Knoxville  vs.  KnoxviUe  Water  Co.), 
103. 

PiLLSBUBT,  Charles  L.  The  Making  and 
Maintenance  of  Priced  Inventories  of  Public 
Utilities,  171-178. 

PoLAKOv,  Walter  N.  Correct  Valuation  of 
Operating  And   Managerial    Methods,    190. 

Potter,  Alexander,  187-188. 

Present  worth  of  business,  141-143. 
Knoxville  vs.  Knoxville  Water  Co.; 
Consolidated  Gas  Case,  Des  Moines  Gas  Case. 

Prices:  changes  in,  162;  determination  of,  6,  53; 
competition  and,  8;  increasing,  effect  of,  221; 
normal  competitive,  162. 

Private  ownership,  of  utilities,  11,33. 

Production,  normal  cost  of,  51. 

Profits,  150,  166-167,  221. 

Property:  Amount  invested  in,  4;  compensation 
for,  taken  for  public  use,  49;  cost  of,  as  deter- 
mination of  value,  94;  estimation  of  value  of, 
4;  income  of,  96-97;  measure  of  value  for  pri- 
vate and  quasi-public,  48;  public  use  of,  38; 
reduction  of  income  of,  5;  value  of,  26,  143, 
210. 

rights:  In  reproduction  cost,  21;  of  utili- 
ties, 32. 

Protest  against  regulation,  168. 

Proutt,  Charles  A.  The  Meaning  of  the  Con- 
stitutional Protection  in  Valuation,  204-208. 
See  also  22. 

Public,  and  utility,  relation  between,  21. 

callings,  defined,  211. 

opinion,  effect  of,  222. 

Service  Commissions,  importance  of,  207. 

Railroads:  As  public  highways,  88-89;  investi- 
gation of,  10;  property  invested  in,  94;  value 
of,  91  (  See  Common  Carriers). 

Railway  company,  construction  organization  of, 
163. 

Rate  basis,  money  and  management,  31-33. 

making,  4,  61-62,  73,  151,  157-158,  204, 

207, 218, 219. 

of  return.  Depreciation  as  a  factor,  103; 

on  costs,  24,  53;  reasonable,  149. 

regulation,  power  of,  48. 

value,  13. 

Rates:  And  service,  63;  basing  of,  on  actual 
original  historical  cost,  21;  determined  in 
franchise,  62;  fixing  of,  62;  from  public  cover 
renewals,  15;  judicial  review  of,  51;  legislative 
function,  29,  30,  31;  made  by  courts,  29;  per- 
sonal judgment,  34;  reasonable,  213;  reduc- 
tion of,  by  government,  5;  reduction  of  light- 
ing, 24;  regulation  of  public  utility,  46  {See 
Return). 

Reforms  in  valuation,  necessary,  203. 

Regulation:  Function  of,  170;  in  financing  util- 
ity, 167;  in  rate  making,  194;  object  of,  171;  of 
monopoly,  193. 

Regulation,  Financul  Aspects  of.  Robert 
C.  Wood,  170-171. 

Renewals:  Actual  cost  of,  43;  as  a  charge  to  op- 
erating expenses,  115;  cost  of,  122;  expendi- 
tures for,  116;  in  actual  cost,  43. 

Repairs,  additions  and  extensions  considered, 
180. 


Replacement  value,  13. 

Reproduction:  Depreciation  and,  52;  origin  of 
use  of,  19. 

cost:  Agency  theory,  22;  an  estimate,  17; 

and  property  rights,  21;  competitive  theory, 
22;  conception  of,  56;  decrease  in,  56;  fair  re- 
turn, equitable,  20;  cost  in,  19,  78;  impor- 
tance, 20;  in  New  Haven  Railroad,  28;  less 
than  going  value,  24;  misconception  of,  18; 
modifications,  36;  cost  of,  18,  26;  origin,  29; 
original  conditions,  35;  outgrowth  of  court 
rulings,  27. 

Reproduction  Cost,  Relation  of,  to  Fair 
Value.    Morris  Knowles,  17-22. 

Reproduction  Cost  Theory,  Fallacy  of,  in 
Determining  Value  of  Property  of  Pubuc 
Utilities.     A.  B.  du  Pont,  25-27. 

Reproduction  Cost  Theory,  How  to  Get  Rid 
of.     G.  W.  Anderson,  28-36. 

method,  accounts  applied,  52;  application 

of,  85;  fallacy  in,  52;  an  estimate,  17;  viewed 
by  Supreme  Court,  16. 

Reproduction  theory,  5-12,  17-21,  39,  40,  177, 
180. 

Reproduction  Theory  op  Valuation,  A 
Criticism  of.    John  M.  Eshleman,  5-12. 

Reproduction  Theory  op  Valuation,  A 
criticism  of.  Discussion  of  Mr.  Eshleman's 
paper,  Halbcrt  P.  Gillette,  22-25. 

Reproduction  value,  12-17. 

Reproduction  Value  vs.  Fair  Value.  H. 
Findlay  French,  12-17. 

Reserves:  For  depreciation,  use  of,  221;  how 
handled,  119. 

Return,  10,  36,  52  (See  Rate  of  Return). 

Right  of  way,  relation  to  reproduction  costs,  14. 

Risk:  And  franchise  values,  71;  in  reproduction 
cost,  33;  in  utilities,  27. 

Roadbed,  as  capital,  29. 

Sales,  basing  of  land  valuation  upon. 

Sakolski,  A.  M.,  99,  100,  133. 

San  Diego  Land  Com,pany  vs.  National  City  on 

due  process,  46. 
Savage,  Judge,  on  going  concern  value  {Bruns- 

wick  Water  Dial.  vs.  Maine  Water  Co.),  144. 
Schaff,  Morris,  137-138. 
Securities;  Amount  of,  35;  protection  of,  32. 
Seidman,  Frank  E.,  134. 
Ser\'ice:  At  reasonable  rates,  154;  charges  for, 

117;  going  value  and,  70;  in  special  franchises, 

63;  rendered  by  transportation  companies,  91.  . 
Sinking  fund,  101,  105  {San  Joaquin  &  Kings 

R.  C.  &  I.  Co.  vs.  Stanislaus  Co.),  116. 
SiNSHEiMEB,   Paul  A.     Financial  Aspects   of 

Valuation,  165-169. 
Sloan,  Judge  Robert,  on  going  value,  16. 
Smythe  vs.  Ames,  16,  25. 
Somers  system  of  land  valuation,  87. 
Speculation,  193,  194. 
Spokane  Rate  Case,  Agency  Theory,  22. 
Standardization:  Need  of,  175,  176;  of  rules  for 

regulation,  170. 
Stearns,  Frederic  P.    Depreciation  Defined, 

100-101.  See  also  39,  66,  57. 
Stephens,  Frank  W.,  weaknesses  of  reproduc- 
tion theory,  39. 
Stevens,  F.  W.    Discussion  of  Principles  to  be 

applied  in  valuing  land,  92-96.    See  also  55, 

92,98,191. 


226 


THE      UTILITIES      MAGAZINE 


Stockholders:  Rights  of,   31;  tummg  over  of 

funds  collected  for  depreciation  to,  118. 
Stock  and  bond  issues,  California  practice,  165. 
Superior,  Wise,  utility  losses  in,  158. 
Surplus,  from  reproduction  cost,  28. 

Tax  cases,  depreciation  in  {Peo.  ex.  rel.  Brooklyn 

Hta.  R.  R.  Co.  vs.  St.  Bd.  of  Tax  Comms.  69; 

Misc.  646),  109. 

law.  New  York,  on  franchises,  69. 

Taxation,  59,  218;  franchise  values,  59-61;  net 

earnings  for,  60;  valuation  for,  68. 
Telephone  business,  reproducing  a,  14-15. 
The  Utilities  Bureau,  4,  188. 
Thelen,  Commissioner  Max,  28. 
Theoretical  depreciation,  a  criticism,  124-126. 
Thorne,  Clifford.   Going  Value  as  an  Element 

of  Fair  Value,  138-152.     See  also  158, 160. 
Threat  price,  basis,  7,  8. 

Unearned  increment,  33,  36,  217. 

Unit  costs,  11,  176,  177. 

prices,   45,   161,   221;   determination   of, 

162-163;  in  valuation,  101-165;  normal,  163; 

of  labor,  45. 
Unit  Prices,  The  Problem  of,  in  Valuation. 

M.  G.  Glaeser,  161-165. 
Utilities,  losses  of,  158. 


Utility  franchises,  condemnation  of,  74-76. 
— — •  managers,  31. 
theory  of  value,  5. 

Vaientine,  a.  L.  Discussion  of  Papers  by  Mr. 
Prouty  and  Mr.  Kerr,  217. 

Valuation:  35,  68,  77,  140-141,  161-169,  218. 
Object  of,  138,  172,  179,  218;  of  commission 
when  conclusive,  206;  of  franchise,  court 
practice,  76. 

Valuation  act,  carriers,  42,  88. 

Valuation  and  the  Future  of  Public  Utili- 
ties.    Milo  R.  Maltbie,  218-222. 

Valuation  by  Approximation.  John  G. 
Morse,  183-187. 

Valuation,  Constitutional  Protection  in. 
The  Meaning  op  the.  Charles  A.  Prouty, 
204-208. 

Valuation,  Constitutional  Protection  in. 
William  D.  Kerr,  208-215. 

Valuation,  Constitutional  Protection  in. 
Newton  D.  Baker,  215-216. 

Valuation  Cases,  Expert  (or  Opinion)  Tes- 
timony IN  Rate.    John  H.  Gray,  192-204. 

Valuation,  Correct,  or  Operating  and  Man- 
agerial Methods.    Walter  N.  Polakov,  190. 

Valuation  experts,  bias  of,  197-199. 


Valuation,  Financial  Aspects  of.  Paul  A. 
Smsheimer,  165-169. 

Valuation  in  Land,  Principles  in.  Frank  W. 
Stevens,  92-96. 

Value:  5,  25,  26,  29,  60,  67,  93-95,  210,  214; 
Kinds  of,  12-13;  literal  or  figurative  mean- 
ing, 213;  meaning  of,  93;  of  non-physical 
elements,  a  criticism,  18;  of  public  utility  prop- 
erties, 171;  standard  of,  162;  upon  what  de- 
pendent, 26. 

Values,  intangible,  139. 

Valuing  land:  Method  used,  78;  principles  ap- 
plied, 77-84. 

Western  Advanced  Rate  case,  28. 

White,  Justice,  on  franchise  value,  76. 

Whitten,  Robert  H.  Actual  Cost,  51-53 
{See  also,  16,  29). 

Whigmore,  John  H.,  199. 

Wilcox  vs.  Consolidated  Gas  Company,  30. 

Wilcox,  Delos  F.  Principles  as  to  Franchise 
Values,  59-67. 

Witnesses,  with  pecuniary  interest,  199. 

Wood,  Robert  C.  Financial  Aspects  of  Regu- 
lation, 170-171. 

Young,  Allyn  A.,  132,  134,  135. 


INDEX 


227 


CITATION  OF  IMPORTANT  CASES  REFERRED   TO  IN  THE   TEXT 


Atfy.  Gen.  vs.  Haverhill  Gas  Light  Co.,  215  Mass. 

394. 
Brymer  vs.  Butler  Water  Co.  (1897),  179  Pa.  St. 

231. 
Buffalo  Gas  Case,  3  P.  S.  C,  2d  Dist.  N.  Y.  553. 
Brunswick  Water  Dist.  vs.  Maine  Water  Co.,  99 

Me.  371. 
Cataract  Case. — City  of  Buffalo  vs.   The  Cata- 
ract Power  and  Conduit  Co.,  3  P.  S.   C.  2d 

Dist.  N.  Y. 
C.  C.  &  A.  R.  vs.  Gibbes,  142  W.  S.  386. 
Cedar  Rapids  Water  Co.  vs.  Cedar  Rapids,  118 

Iowa  234. 
Cedar  Rapids  Gas  Light  Co.  vs.  City  of  Cedar 

Rapids,  223  W.  S.  665. 
Central  Transportation  Co.  vs.  Pullman  Palace 

Car  Co.,  39  W.  S.  24. 
Chi.  etc.  Kg.  Co.  vs.  Minn.,  134  W.  S.  418,  461. 
City  of  Knoxville  vs.  Knoxville  Water  Co.  (1909), 

212  W.  S.  1. 
Consolidated  Gas  Co.  vs.  N.  Y.,  157  Fed.  849. 
Consolidated  Gas  Case,  212  U.  S.  19. 
Catting  vs.  Kansas  Stock  Yards  Co.,  183  U.  S.  79. 
Covington   &  Lexington  T.  R.  Co.  vs.  Sanford, 

164  U.  S.  578. 
Covington  &  Lexington  Turnpike  Co.  vs.  Sand- 
ford,  164  U.  S.  578. 
Contra  Costa  Water  Co.  vs.  Oakland  (1911),  159 

Cal.  323. 
Cumberland  Tel.  &  Tel.  Co.  vs.  City  of  Cumber- 
land (1911),  187  Fed.  637. 
Cumberland  Tel.  &  Tel.  Co.  vs.  City  of  Louisville, 

187  Fed.  637. 
Des  Moines  Water  Co.  vs.  City  of  Des  Moines 

(1911),  192  Fed.  193. 
Des  Moines  Gas  Co.  vs.  City  of  Des  Moines,  238 

U.  S.  113. 
Devon  vs.  City  of  Cincinnati,  162  Fed.  R.  633. 
Dow  vs.  Beidelman,  125  U.  S.  680. 
Fall  River  Gas  Works  Co.  vs.  Board  of  Gas  & 

Elec.  Light  Comm.,  214  Mass.  529. 
Gates  <fe  Hurtley  vs.  Delaware  &  Atlantic  T.  &  T. 

Co.  Com.,  519. 
Gulf  etc.  R.  Co.  vs.  EUis,  165  U.  S.  150. 
Gloucester  Water  Supply  Co.  vs.  Gloucester,  179 

Mass.  365. 
Hill  et  al  vs.  Antigo,  etc.,  3  Wis.  Com.  623. 
Hobart  Pillsbury  et  al  vs.  People's  Gas  Light  Co., 

32  Com.  Leaf  608. 
Home  Tel.  Co.  vs.  City  of  Carthage,  235  Mo.  644. 
Interstate  Com.  Comm.  vs.  Chicago  Great  Western 

Ry.  Co.,  209  U.  S.  108. 
Interstate  Commerce  Comm.  vs.  Louisville  &  N. 

R.  R.  Co.,  227  U.  S.  88. 
Interstate    Commerce    Commission    vs.     Union 

Pacific  R.  R.,  222  U.  S.  541. 


In  re  Application  La  Crosse  Gas  &  Elec.  Co.,  8 

Wis.  Com.  138. 
In  re  Blue  Hill  Street  R.  Co.  P.  W.  R.  (1915), 

E.  386. 
In  re  Public  Service  Gas  Case,  I.  N.  J.  Rep.  433. 
In  re  Rates  of  Queens  Borough  Gas  &  Elec.  Co., 

2  N.  Y.  Com.  1st.  Dist.  544. 
Jeffrey  Mfg.  Co.  vs.  Blogg,  35  Sup.  St.  Rep.  167. 
Kansas  City  vs.  National  Waterworks  Co.,  62 

Fed.  853. 
Kansas  City  So.  Ry.  Co.  vs.  U.  S.  (1913),  231 

U.  S.  423. 
Kennebec  Water  Dist.  vs.  Waterville,  97  Me.  185. 
Kings  Co.  Lighting  Co.  vs.  Willcox,  2  P.  S.  C. 

1st.  Dist.  N.  Y.  680. 
Knoxville  vs.  Knoxville  Water  Co.,  212  U.  S.  1. 
L.  &  N.  R.  R.  Co.  vs.  Garrett,  231  U.  S.  299. 
L'Hote  vs.  New  Orleans,  177  U.  S.  587. 
Lincoln  Gas  &  Elec.  Lt.  Co.  vs.  City  of  Lincoln 

(1909),  182  Fed.  926. 
McGregor-Noe  vs.  Springfield  Gas  &  Electric  Co., 

1  Mo.  Com.  468. 
M.  &  St.  L.  R.  Co.  vs.  Beckwith,  118  U.  S.  394. 
M.  &  St.  L.  R.  Co.  vs.  Herrick,  127  U.  S.  210. 
Marchant  vs.  Penn.  R.  R.,  153  U.  S.  380. 
Maghen  vs.  King  Co.  Lighting  Co.,  2  N.  Y.  Com. 

1st.  Dist.  659. 
Metropolitan  Bank  vs.  St.  Louis  Dispatch  Co., 

149  U.  S.  436. 

Metropolitan  Trust  Co.  of  N.  Y.  vs.  Houston  & 

Texas  Cent.  R.  R.  Co.  (1898),  90  Fed.  683. 
Middlesex   &   Boston  Rate  Case,   2   P.  S.  C. 

(Mass.)  111. 
Minneapolis  Street   Railway   Fare   Case,    215 

U.  S.  417. 
Minnesota  Rate  Case, — Simpson  vs.  Shepard, 

230  U.  S.  352. 
Monongahela  Navigation  Co.  vs.  U.  S.,  148  U.  S. 

312. 
Mugler  vs.  Kansas,  123  U.  S.  623. 
Munn  vs.  People  of  Illinois,  94  U.  S.  113. 
Murray  vs.  Publ.  Util.  Comm.  of  Idaho  (1915), 

150  Pac.  R.  47. 

Nat'l  T.  Co.  vs.  His  Majesty's  P.  M.  Genl.  (1913), 
16  A.  T.  &  T.  Co.  L.  491. 

Newburyport  Water  Co.  vs.  Newburyport,  168 
Mass.  543. 

Norfolk  and  Western  Railway  Company  vs.  Con- 
ley,  236  U.  S.  605. 

Northern  Pacific  Railway  Company  vs.  State  of 
North  Dakota,  236  U.  S.  585. 

Norwich  Gas  &  Elec.  Co.  vs.  City  of  Norwich, 
76  Com.  565. 

Omaha  vs.  Omaha  Water  Co.,  218  U.  S.  180. 

Passaic  Gas  Case,  N.  J.  Bd.  of  Pub.  Util. 
Com.,  Vol.  I,  433. 


Payne  et  al  vs.  Wisconsin  Tel.  Co.,  4  W.  R.  C.  R. 

51. 
Pembina  etc.  Co.  vs.  Pennsylvania,   125  U.  S. 

181. 
Pioneer  T.  &  T.  Co.  vs.  Westenhaver  (1911),  29 

Okla.  429. 
Peo.  ex  rel  Brooklyn  Hts.  R.  R.  Co.  vs.  State  Bd. 

of  Tax  Comm.  (1910),  69  Wis.  646. 
Peo.  ex  rel  Binghamton  Lt.  Ht.   &  Pr.  Co.  vs. 

Publ.  Serv.  Comm.  (1911),  203  N.  Y.  7. 
Peo.  ex  rel  Jamaica  Water  Supply  Co.  vs.   Tax 

Comms.  (1909),  196  N.  Y.  39. 
People  ex  rel  Kings  Co.  Ltg.  Co.  vs.  Publ.  Serv. 

Comm.  (1913),  156  N.  Y.  App.  Div.  6C3. 
People  ex  rel  Westchester  Elec.  R.  R.  Co.  vs.  Pub. 

Serv.  Comm.  (1913),  158  App.  Div.  251,  afifd. 

210  N.  Y.  456.  211  N.  Y.  533. 
Prentis  vs.  Atlantic  Coast  Line,  211  U.  S.  210. 
Publ.  Ser.  Gas  Co.  vs.  Board  of  Pub.  Utility  Cor- 
porations (1903),  87  Atl.  651. 
Reagan  vs.  Farmer's  Loan  &  Trust  Co.,  154  U.  S. 

362. 
Santa  Clara  County  vs.  So.  Pac.  R.   Co.,   118 

U.  S.  394. 
San  Joaquin  &  Kings  R.  C.  &  I.  Co.  vs.  Stanis- 
laus Co.  (1911),  191  Fed.  875. 
San  Diego  Land  Co.  vs.  National  City,  174  U.  S. 

739. 
San  Diego  Water  Co.  vs.  San  Diego,  118  Cal. 

656. 
Smythe  vs.  Ames,  169  U.  S.  466. 
South  etc.  Ry.  Co.  vs.  Railroad  Commission,  210 

Fed.  R.  465. 
Spokane  Rate  Case, — U.  S.  I.  C.  C.  et  al  vs. 

A.  T.  &  D.  F.  et  al,  234  U.  S.  476. 
Spring  Valley  Water  Co.  vs.  City  &  County  of 

San  Francisco,  165  Fed.  667. 
Spring  Valley  Waterworks  vs.  City  of  San  Fran- 
cisco, 192  Fed.  137. 
Spring  Valley  Waterworks  vs.  City  and  County  of 

San  Francisco,  124  Fed.  574. 
State  Journal  Ptg.  Co.  vs.  Madison  Gas  &  Elec. 

Co.,  i  Wis.  Com.  501. 
Stanislaus  County  vs.  San  Joaquin  Co.,  192  U.  S. 

201. 
Superior  Commercial  Club  vs.  Sup.  U.  S.  &  P. 

Co.,  10  Wise.  Comm.  704. 
Talcott  vs.  Pine  Grove,  23  Fed.  Cases  652. 
U.  S.  vs.  Joint  Tariff  Association,  181  U.  S.  505. 
U.  S.  vs.  Kansas  Pac.  R.  R.  Co.  (1878),  99  U.  S. 

455. 
Western  Advance  Rate  Case,  20.1.  C.  C.  R. 

332. 
Western  Advance  Rate  Case,  20  L  C.  C.  R. 

307. 
Wilcox  vs.  Cons.  Gas.  Co.  212  U.  S.  19. 


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